Find Your Inner Soros

In yesterday's HX Daily, we profiled legendary investor George Soros.

In that piece, we mentioned his theory of "reflexivity.”  This is a powerful insight into how the markets work at pivotal points—an insight that, if properly harnessed, can make you a LOT of money as an investor.

Today, we share a piece we wrote a couple of years ago that walks through the basics of this concept.

The note was written during the heart of the COVID period, a time when "reflexivity" was evident in the markets.

Although the current environment is quite different, we think the same insights still apply. When "reflexivity" emerges again, be ready!

Regular HX Research readers are familiar with one of the most essential concepts in this newsletter...

We are buying stocks, not companies.

When you buy a share of stock, you own an economic stake in a business. This means that the stake technically gives you the legal right to the cash flows of that business.

In reality, that doesn't mean a whole lot.

Most companies don't pay out that cash flow, and even if they do—via dividends—it's only a small amount.

In fact, some of the best stocks (and companies) of all time have never paid investors a dime of their cash flow. For instance, just look at e-commerce titan Amazon.com, Inc. (NASDAQ: AMZN) and Warren Buffett's Berkshire Hathaway Inc. (NYSE: BRK/B).

Unlike a bond (where there are real cash flows), stocks are valued based on opinions. You can have the same business trade at dramatically different values at any given point.

The only difference is that investors' perception of value may differ for several reasons. Frankly, those reasons don't really matter, only that you can identify them.

The popular phrase "perception is reality" is often true when it comes to stocks. Legendary investor George Soros illustrates one of the best concepts of this.

Soros adapted a sociology term—"reflexivity"—and applied it to economics. Reflexivity refers to the idea of a feedback loop: Investors' perceptions can affect economic fundamentals, which in turn can change investor perceptions.

Let's use a bank as an example. Banks take deposits from customers and then make loans equal to a multiple (five to 10 times) of those deposits. Those loans will pay out over many years. As long as all the depositors don't come and ask for their money back at once, it's no problem.

However, depositors may rush to withdraw their money if they become concerned about the bank's viability. The more people who withdraw their money, the more people become concerned, and the next thing you know, there's a "run on the bank," and the whole structure collapses.

Reflexivity is a powerful concept. Soros notes that if you can identify where something like this is about to happen, you've found a massive moneymaking opportunity.

Here at HX Research, I've frequently discussed the effect of human psychology and biology on financial markets, and these reflexive situations contribute to this.

Human beings are inherently emotional. They become excited (greedy) and panicked (fearful). Identifying where those emotions are about to flare up can be a great way to identify winning investment opportunities.

These concepts are always applicable to the stock market... but sometimes they're more useful than at other times.

Right now is one of those times.

The U.S. Federal Reserve and other global monetary authorities have injected a massive amount of liquidity (cash) into the economy to get us through the COVID-19 crisis. More cash in the economy means more cash to buy assets – including stocks.

Combined with the high degree of uncertainty – a highly "emotional" time – in the markets and several emerging technology areas such as electric vehicles and online gambling, we have a stock market where perception can become a reality.

Just look at what has happened to the bankrupt car rental company Hertz Global Holdings, Inc. (NYSE: HTZ) in the past few weeks.

As a result of the COVID-19 crisis, Hertz was thrust into bankruptcy late last month. In almost every scenario, a stock in bankruptcy is eventually worth almost nothing.

But despite that, HTZ shares went from an intraday low of $0.40 in the wake of the bankruptcy filing to an intraday high of more than $6 on June 8.

Yesterday, they closed at $1.24. Again, these shares are almost certainly worthless.

And that wasn't all. Shortly thereafter, Hertz made the wild statement that it might issue new shares to investors.

Hertz didn't go bankrupt because its rental car model was genuinely flawed. The company had a risky amount of debt on a well-operating business. But Hertz couldn't pay that debt when that business collapsed because of the COVID-19 crisis.

Had Hertz been able to find an equity investor to "bridge" it through this period, the company might have survived.

In theory, if enough investors felt it was worth the investment, they could have given Hertz enough money not to go bankrupt.

2024 Editor’s Note - This unlikely scenario is exactly what happened at HTZ. The recovery in the stock enabled the company to avoid bankruptcy.

Investor’s perception of reality literally changed the outcome. This is one of the most powerful instances of Soros’ “reflexivity” we have seen in our three-decade career!