It has often been quoted in the media and by mainstream analysts that economic recessions are the root cause of "bear markets" in stocks. However, is that really true?
George Soros once discussed the idea of "reflexivity"
"Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever, and if the underlying reality remains unchanged, it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals."
By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually, market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity, but they are the most spectacular."
This idea of reflexivity is important in understanding the relationship between market psychology and the ultimate outcome of the markets themselves. While the vast majority of the media and analysts continue to assert the markets are fine because there is currently "no signs of recession," it ignores the impact of the psychology of the participants.
recently noted the same stating:
"The basic assertion is the following: the U.S. economy is not showing signs of entering into recession, thus stocks are not at risk of falling into a sustained bear market. Unfortunately, this conclusion is not necessarily true. For history has shown on numerous occasions that you do not need to have an economic recession looming on the horizon to see U.S. stocks fall into a bear market."
Eric is correct on his point for two very important reasons:
- Bear markets are a result of the switch of market psychology from "greed" to "fear" driven by an event that leads to a broad market "selling panic" that triggers a negative feedback loop in the market. (reflexivity)
- Recessions are coincident with market declines ONLY IN HINDSIGHT. The reason is due to the annual revisions to past economic data that only reveal the start and end of the recession after the fact.
Ponder this for a moment. If the above statements are true, then it is NOT recessions that cause bear markets but rather "bear markets" that cause recessions.
Giving credence to this thought was the Ben Bernanke's own admission in 2010, as he announced the start of the QE-2, that supporting asset prices was important to consumer confidence.
In other words, falling asset prices reduce consumer confidence, and thereby their consumptive activity, which sparks the onset of economic recessions.
As Eric correctly notes:
"In a number of cases over the past century, a bear market in U.S. stocks was well underway long before a recession had taken hold of the U.S. economy."
The point is simply this: If you are waiting for the confirmation of a recession before taking actions to protect your investment portfolio, it will likely be far too late.
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