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We may be seeing bubbles blowing up in some equity markets right now. Others may follow. We need to be able to read the signs of both the blow-up and any potential crash. George Soros’s reflexivity model can help.
Soros sees bubbles as consisting of two components:
(i) a trend based on reality
(ii) a misconception or misinterpretation of that trend
Usually financial markets correct misconceptions, but, occasionally misconceptions can lead to the inflation of a bubble. This happens when the misconception reinforces the prevailing trend.
Then a two-way feedback might occur in which the prevailing trend, now puffed up by the initial misconception, then reinforces the misconception.
Then the gap between reality and the market’s interpretation of reality can grow and grow.
In maintaining the growth in the gap, the participants’ bias needs a short circuit so that it can continue to affect the fundamentals. This is usually provided by some form of leveraged debt or equity.
At some point the size of the gap becomes so large that it is unsustainable. The misconception is recognised for what it is, and participants become disillusioned.
The trend is reversed. As asset prices fall the value of collateral that supported much of the loans for the purchases melts away, causing margin calls and distress selling. Eventually, there is an overshoot in the other direction.
The boom/bust sequence is asymmetrical. It slowly inflates and accelerates, followed by a more rapid reversal. The stages of a number of examples drawn from history are described in later newsletters.
Soros says that there are eight stages to the boom/bust sequence. We will take the example where the underlying trend is earnings per share (‘the prevailing trend’) and the participants’ perceptions (cognitive function) are reflected in share prices through the manipulative function, i.e. they buy or sell shares pushing the prices up or down.
In turn, the change in share prices may affect both the participants’ bias and the underlying trend.
Thus, share prices are determined by two factors:
(a) the underlying trend – eps
(b) the prevailing bias
Both (a) and (b) are influenced by share prices, hence a feedback loop.
In the figure below the divergence between the two curves is an indication of the underlying bias. (Soros said that the true relationship is more complex than we are representing here because the earnings curve includes, as well as the underlying trend, the influence of share prices on that trend. Thus the prevailing bias is expressed only partially by the divergence between the two curves – it is also partially already reflected in those curves.)
The boom/bust model
Stage 1 – no trend recognition
The underlying trend is gently sloping upwards, but is not yet recognised
Stage 2 – recognising the trend and reinforcement
The trend is recognised by market participants. This changes………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
