George Soros (Trades, Portfolio) has a fantastic reputation of being one of the greatest investors. He has attributed his success to a theory he started developing back in the 1950s. This theory helped him build a framework to navigate macroeconomic environments.
Soros calls this the theory of reflexivity. It is based on the idea that feedback loops between expectations and economic fundamentals can cause price changes that substantially and persistently deviate from equilibrium prices. Soros explained this idea in an article in the Financial Times in 2009:
"I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants' view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity."
Soros went on to explain that the idea of treating drug addicts as criminals is the perfect example of reflexivity as it misconstrues the problem and interferes with the proper treatment of addicts.
Reflexivity in financial markets
In the financial markets, we can see reflexivity in progress every single day. The distorted views of individual market participants can lead to different outcomes for securities that do not represent the underlying company's fundamentals.
Two perfect examples at the moment are Tesla (TSLA, Financial) and AMC (AMC, Financial). The market participants involved in buying and selling each security have a different view of the world, and their views influence the whole situation.
In both cases, these two organizations have effectively reduced their cost of capital to zero due to high stock prices. As a result, both companies have drastically improved their financial positions by raising money from the market with almost no cost whatsoever.
The impact this has had on these two companies cannot be understated. For example, towards the end of last year, Tesla announced it would be raising $5 billion through an at-the-market offering of shares. A few years ago, this sort of cash call would have had a substantial negative impact on the stock price, but the market was happy to absorb the extra shares on this occasion. This provided Tesla with a massive cash infusion to fund its growth program. I think it's unlikely this would have been possible without the backing of the market.
Meanwhile, over the past six months, AMC has returned to the market several times to raise new money by issuing shares. In theory, the company could try and reduce its debt down to zero by issuing new shares. This would completely change the investment's outlook. In 2019, AMC's gross interest expense totaled $341 million, and it reported a loss of $172 million. Without the hefty interest charges, the company could become profitable.
Another example is GameStop (GME, Financial). Like AMC, the company has experienced to stratospheric increase in its share price as a so-called meme stock. Management has taken advantage of this to raise new capital, and it is using the new capital to fund an expansion into e-commerce. Before investors started pushing the stock higher, this was a struggling brick-and-mortar retailer with declining sales and limited prospects. Now it has a brighter future.
Market sentiment matters
In each of these three examples, improving market sentiment has driven a virtuous cycle. As shares in each company have risen in value, more investors have become involved, which has pushed the stock higher, allowing the company to raise capital, helping to strengthen the balance sheet and attracting more investors. It's a version of Soros' theory of reflexivity in action.
These case studies show why investors need to be aware of the impact of market sentiment on equity prices. Improving market sentiment can dramatically improve a company's prospects. But, on the other hand, deteriorating market sentiment can make it harder for a company to raise capital and attract talent.
