A story about the ‘Theory of Reflexivity’ and India’s stock markets

India’s stock market has hit a rough patch. It is down 10% from its peak.?

In case you’re wondering, the technical term for this is a ‘correction’. We’re not in a bear market yet because that’s technically a 20% fall or more.

But the thing is that if this downward trend continues for a while, it could turn out to be a niggling worry for our economy.?

And that’s because of the ‘theory of reflexivity’.?

It’s something that hedge fund manager George Soros came up with during the 1980s. And in the simplest terms, it means that stock prices can impact the fundamentals of the underlying economy.?

Yup, he says that if stock prices are lower,? it can push economic growth lower.

Okay, hold on. You might ask – Isn’t it the other way around? Don’t economic events affect stocks? Because if you think about it, if the economy slows down and people stop buying stuff, that will hurt the sales of companies and eventually have a knock-on effect on stock prices. Right?

That’s true.?

But Soros’s theory is that if we understand feedback loops based on expectations, we understand reflexivity.?

And maybe the best way to do that is by looking at how a positive feedback loop works first.?

Let’s say that investors have a positive view about the future. They believe the economy is on the right path. And anticipating that this economic growth will fuel the growth of companies, they begin to buy stocks. This pushes the stock prices higher and company valuations soar. This then has a positive impact on the folks running these companies. They see their value rising and decide that the time is ripe to invest in adding more capacity or expanding. They think this will further help their profits. And when other investors see this happening, they get more optimistic. They buy stocks and as their wealth appreciates, they feel richer and spend their money consuming stuff too. And this becomes a virtuous cycle.

Or simply put, the expectation of economic growth eventually creates economic growth.?

And as per Soros, this happens due to the principle of fallibility. Or in his words,

“that in situations that have thinking participants, the participants’ views of the world never perfectly correspond to the actual state of affairs. People can gain knowledge of individual facts, but when it comes to formulating theories or forming an overall view, their perspective is bound to be either biased or inconsistent or both.”

Or in simple words – reflexivity happens because human beings aren’t rational.?

But, we’ve only explained one side of reflexivity. Since nothing good lasts forever, the perception can quickly shift towards a negative feedback loop too.?

Any piece of good news is brushed aside and people look past it to find the negatives. They start to dump their stocks and companies find it hard to raise money anymore. The confidence is dented and investments into projects slow to a crawl. That hurts wage growth and people tighten their purse strings. Eventually, that cascades into the economic engine sputtering.?

Is that what’s happening in India?

It’s hard to say. We’ve experienced the positive feedback loop in the past few years. It probably had a big part to play in the booming stock markets. And it even catapulted us to the top of the world’s fastest growing major economies.?

But now, consumption is dropping. There’s also news that our GDP growth for the second quarter of this financial year (July to September) will be weak thanks to a slowdown in manufacturing.?

And this is making the government worried too. Just last week, Piyush Goyal, who heads the ministry for industry, and Nirmala Sitharaman, who leads our country’s finances, suggested that the Reserve Bank of India should cut interest rates. The theory being that if interest rates are low, businesses and people will be tempted to borrow money and spend.?

We don’t know yet if all this is indeed due to the emergence of a negative feedback loop. It could be just a tiny, temporary blip in India’s growth story.?

But maybe one thing that could give us a true picture is by looking at the SIP data.?

Because we’ve all seen the numbers. From a monthly SIP flow of just? ?8,000 crores in March '19, it has ballooned to a massive ?24,500 crores a month. Everyone has been investing.

But if that faces any hiccups, if people stop their SIPs, it could be a telltale sign that people are worried about investing.?

And if you look around, you’ll hear the whispers already. There seems to be some nervousness in the air right now. The number of new SIP accounts being added every month has slowed down. The stoppage of SIPs has also hit a 5-month high.?

And if the theory of reflexivity holds good, and investors in the stock market panic, it will eventually affect the fundamentals of our economy too negatively.?

So yeah, now you understand why there are a few furrowed eyebrows thinking about how to bring back the animal spirits in the country.

We need it.