Market Reflexivity

Market reflexivity is a term from sociology that is also widely used in the economic world. The definition is closely related to the price level and market sentiment. George Soros is a big name in the field of reflexivity theory, so that’s why we cover his opinion in this article. By educating yourself financially, you can take advantage of it. Understanding technical analysis and the fundamental basics is the foundation of a good trader.

Deep dive into reflexivity #

The theory of reflexivity is about the fact that investors do not make their decisions based on reality, but on their perception of reality. So, they frame their reality, make decisions and carry out actions. Perceptions arise from these actions, which have an impact on reality. As a result, prices on the market change, which also changes the reality in the eyes of investors.

According to George Soros, this process is self-reinforcing and causes price imbalances in the market. According to the investor, the current economic situation is a textbook example of the theory: rising house prices lead to an increase in the number of mortgages, which in turn causes prices to rise again. As a result, we massively form one bubble after the other, until it collapses. You can guess the result: a financial crisis, such as the Great Recession between 2007 and 2009.

Although the standard assumption is an economic equilibrium in combination with a rational expectation, Soros runs counter to this. According to most economic models, an equilibrium price is established through supply and demand. According to the average economist, the price decreases when it is rationally expected that demand will fall. Conversely, the price rises when demand increases or when there is scarcity.

George Soros does not fully agree with this, because he believes that reflexivity upsets this balance. Price developments never stand still and if we keep making decisions based on what we consider our reality, the gap between reality and the level of the market prices is widening. The aforementioned feedback loop causes a discrepancy between prices and expectations. When something changes in the economy, a positive adjustment occurs through the feedback loop. A negative feedback loop would keep the market in equilibrium, but the normal reaction is not forthcoming. This causes the economic equilibrium to disappear until the participants in the market wake up and see that reality has become detached from market prices. The trend then reverses temporarily, but George Soros does not view this as negative feedback.

Reflexivity in the crypto market #

Crypto is still in its infancy, so there are still severe fluctuations in the market: the so-called volatility. In addition, as crypto enthusiasts we are constantly bothered by FOMO and always discover a new gem somewhere.

It is often in the news that the entire crypto market depends on the developments surrounding Bitcoin (BTC), but if you have a little knowledge, you know that this is pure ignorance. As the market matures, the approach will grow with that maturity. Because the market is so novel, it is subject to fluctuations quite quickly. The fluctuations are caused by events in the market, causing cryptos to react negatively or positively.

Developments around Bitcoin #

The fact that Bitcoin (BTC) is considered a financial revolution has a major impact on reflexivity. Statements such as ‘Bitcoin is an unstable factor that will never survive as a serious means of payment’ also influence the market. These are both not factual matters, but sentimental events. These statements have a major influence on the price effect around the coin. Are we flocking to Bitcoin as the coin is taking a leap and positive in the news? Then the popularity increases and so does the price. If the price collapses, as is the case at the time of writing (May 2022), many people will sell and it will go for the proverbial dime.

Bitcoin’s price development is relevant to the entire crypto market, as it is an influential resource. This is of course mainly because the market is young and many people hardly know anything about the market and the possibilities. In addition, altcoins often follow the price of Bitcoin, making it actually a self-fulfilling prophecy. For example, many people also predicted that the price of Bitcoin would rise to $200,000 by the end of 2021, which as we know has not happened. Worse yet, we’ve fallen a long way down.

Bitcoin & the feedback loop #

Based on the price shifts in recent years, you can see very well how Market Reflexivity works in practice. In 2020 and 2021, there was a dire bull market, meaning the price is rising and higher than normal. The crypto market was doing very well, until Elon Musk announced that Bitcoin was no longer accepted as a payment method at Tesla. In addition, mining was no longer allowed in China, which changed the sentiment in the market.

Prices fell and tensions prevailed in the crypto market. The panic caused many people to put their coins on sale. This led to even more panic last year, pushing us to a low point. Currently, Bitcoin (BTC) has fallen to 27k, leaving many investors waiting for another price hike and some perspective on the market. So, you see, a reflexive market is fickle and exciting, which has far-reaching consequences for the consumer.

Besides, what also influences the price of Bitcoin is the inflated value and the fact that people have come to see Bitcoin as a Store of Value (SoV). It is also called ‘the digital gold’, because of the value that owners have in their hands. The relationship between the two perceptions causes the price to be pushed up, resulting in reflexivity.

Conclusion #

Despite the fact that reflexivity is basically a sociological term, we will use the term in this article to refer to the economic market. What does the cause-and-effect relationship have to do with the financial market and how does the price adjust to these fluctuations?

In short, reflexivity is the self-reinforcing effect of market sentiment, causing prices to pull through investor perception, until the process becomes unsustainable. George Soros is a big name that is often associated with this definition. He gives a good example based on the current housing market. House prices are rising > more houses are being sold and mortgage loans are being issued > prices are rising further > things are getting out of hand and becoming unaffordable. The market price is no longer in proportion to the intrinsic value, causing the market to collapse.