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Reflexivity in Financial Market Forecasting
Both active traders and investors and forecasters feed the market with information, which drives prices and returns. In this particular model, forecasts affect market prices and returns. But which is the main driver?
Simply put, forecasts from “credible” market participants and economists, particularly those from the sell-side and their consultants, significantly influence market performance. The markets do not care about the forecast of a social media account with a thousand followers but assign high credibility to one from a major bank. This is one reason for insignificant market players to refrain from making forecasts other than enjoying a victory lap at some point in time with some probability—something that no one really cares about, at any rate.
However, overwhelmingly, the sell-side and their consultants are always bullish on the stock market. This creates a positive feedback loop via reflexivity. As a result, the market interprets both positive and negative economic news as bullish drivers. Both passive index investors and the prevailing political economy system benefit from this arrangement. However, the reflexivity may create an economy with a pro-capital bias instead of a pro-labour bias, but this is another important subject that is beyond the scope of this brief article.
Bullish forecasts and reflexivity are the major drivers of stock market returns even under harsh economic conditions. Large corrections and bear markets can and will occur, but their drivers are unexpected events beyond what the reflexivity can absorb. Lately, there is an attempt to absorb these too via the use of powerful narratives. Artificial intelligence has been the dominant narrative in the last two years, amid significant geopolitical turmoil. As this narrative’s power is fading, a new one about quantum computing has emerged, but it does not appear to be as powerful. Yet, most large banks and investment firms predict higher prices for 2025 because they bet on reflexivity: forecasts of higher prices drive the stock market higher, and in turn, higher prices result in forecasts for even higher prices.
As long as passive investing is the dominant style in the US market due to the link between pensions and stock market performance (which was Wall Street’s greatest achievement), this dominant reflexivity cycle will remain intact. However, this dynamic may face an absorbing barrier in case an alternative dynamic asset class emerges that can serve as a store of value. If this ever happens, as there is currently an effort with cryptocurrencies, the stock market, or at least many of its sectors, may face serious challenges.