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On Reflexivity & Animal Spirits: What Moves the Market from Here?

Kent Thune’s wonderful blog The Financial Philosopher is not just a financial site, it’s a "learning experience."  I highly recommend that you visit him and read some of his latest inspirational articles, such as Get Busy Livin’ or Get Busy Dyin’To Embrace Death is to Embrace Life, and Entrepreneurs: Use Your Delusion, Sell the Illusion. – Ilene

On Reflexivity & Animal Spirits: What Moves the Market from Here?

ITAR-TASS 02: IRKUTSK REGION, RUSSIA. NOVEMBER 30, 2008. Early twentieth century German pendulum clock with a statuette of Mnemosyne, Greek goddess of memory, on display at the Clock Museum, Angarsk, Irkutsk Region, Russia. (Photo ITAR-TASS / Nikolai Ryutin) Photo via Newscom

Courtesy of Kent Thune, at The Financial Philosopher

Are capital markets leading economic indicators or do they provide fuel for a growing economy? Or is it both? Isn’t the function of capital markets to raise capital for the financing of corporate and government operations through the sale of securities (stocks and bonds)?

If the stock market is rising, would this not then create the economic condition it is "predicting" as an economic indicator? In the absence of government stimulus, might financial markets save themselves? If so, how? Can financial markets rise spontaneously or do they require a fundamental boost or outside stimulation?

Capital markets have many functions and their participants have numerous objectives; however, we may simplify them all into two basic categorical functions: 1) Passive and 2) Active. Depending upon economic conditions and variables, capital markets can play one or both rolls. Consider recent comments by George Soros (Hat tip to Captain Jack):

…financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified. I call the interaction between the two functions reflexivity…

Mr. Soros’ idea of reflexivity asserts, as he says, "that financial markets do not necessarily tend toward equilibrium; they can just as easily produce asset bubbles." This comes as no surprise to many readers here, but it is useful to remember that financial markets do not act absolutely in passive or active roles; they are not purely efficient or non-efficient, rational or irrational, predictable or unpredictable. Financial markets can create (and build upon) their own energy.

This may be an oversimplification, and subject to intelligent criticism, but financial markets are largely momentum-based. What Mr. Soros might call a "feedback loop" may be considered a self-fulfilling prophecy of sorts: As market participants anticipate economic growth, they will drive equity prices higher, which creates more positive momentum and also supplies capital (financing) for the corporate and government entities selling their securities in the market place, not to mention positive psychological impact (sentiment). These feedback loops, of course, can work in the opposite direction as well.

Excess generally causes reaction, and produces a change in the opposite direction. ~ Plato

The very nature of momentum, if we may consider the swinging of a pendulum, is that the momentum itself increases, in both directions, as other forces (e.g. government stimulus, regulation, deregulation, legislation, media noise, investor sentiment, and so on) act upon it; thereby creating a perpetual cycle of bubble creation and destruction, the latest and greatest example being the credit bubble and ensuing crisis. You know the story: Lower interest rates and easier credit pushed home values higher, which inspired the creation of complex and dangerous investment derivatives. The capital markets did not self-correct until reality caught up with the illusion.

One of the key players in the credit bubble, Alan Greenspan, made a recent comment on Dateline that shines more light on the idea that capital markets can play quite an active role (not just a passive, predictive function) on the economy and their own momentum in either direction:

What created the extent of the contraction globally was the loss of $37 trillion in market value. It collapsed the value of collateral in the system and it disabled finance. We’ve come all the way back–maybe a little more than halfway, and it’s had a very positive effect.

In hindsight, it is clear that the massive decline in market value in 2008 "disabled finance" but may we assume that the swing in the opposite (generally positive) direction in 2009 and 2010 can continue the momentum and fuel higher stock prices?

Now with the pendulum swinging back into positive territory, how much farther can it go without any foreseeable stimulation from outside sources? Are we in a positive feedback loop? Perhaps the market can move higher by fuel from animal spirits, as John Maynard Keynes noted in 1936:

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

So, back to the primary question, and from where we stand today, will the pendulum swing further in the direction of rising stock prices (positive feedback) or are we at a tipping point, headed in the opposite direction (negative feedback), and thus closer to an environment where fundamentals once again direct stock prices? Or will animal spirits save the market? Whatever we discover as the anwers, it is important to note that the market can be moved just as easily by spontaneous momentum as by fundamental forces.

Kent Thune, CFP®, MBA
www.thethinkersquill.com

www.thefinancialphilosopher.com

About the Author: Kent Thune is a Certified Financial Planner (R), a freelance writer, and the blog author of The Financial Philosopher, where he urges readers to place meaning before money and purpose before planning.


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