George Soros is known as the “man who broke the Bank of England” in the early 1990s, but his main contribution to the financial world is the theory of reflexivity, which claims the following:

• Prices aren’t objective; they’re based on people’s biased perceptions of the future

• Biased perceptions define people’s buys and sells, so perceptions will influence prices

• Prices impact perceptions and fundamentals, too

Soros’s reflexivity theory is also a common-sense explanation of why trends exist and why price momentum could be an excellent equity selection filter.

What happens when the price of a stock makes a new all-time high?

1) The market is considered a feedback mechanism. When prices go up, people assume that their initial investment thesis is right and their expectations justified. They buy more and are joined by even more people wanting to participate in the trend. The fear of missing out is ruling market’s behavior.

2) Higher stock prices mean happy shareholders. Since the manager of our company has made his investors a lot of money, he receives a lot of good faith and patience for future experiments. This manager could make a lot bolder moves, and he is given more time to be right.

We have all seen the incredible faith that Amazon’s shareholders have in Jeff Bezos. Sixteen years after its IPO, Amazon still loses money on the occasional quarter, because it invests heavily in new projects. Amazon missed Wall Street’s earnings expectations in four of its last five reports. Any other stock would be killed for missing estimates so many times. Not Amazon. Its stock climbed 50 percent in the past year and a half.

Management is an important part of the fundamentals of one company. When investors trust and believe management, they are willing to give his/her company a lot higher P/E multiple, and for a good reason. Investors tend to trust managers that make them money.

3) The company could use its appreciated stock as a currency to acquire smaller competitors and the best human talent in its respective field, which makes it a lot stronger, functionally and operationally. We see how Google is scooping up many of the best engineers in the world. Better people, new and better products, less competitors are all factors that actually improve a company’s fundamentals, and they could be all derived from higher stock prices. The improved fundamentals attract a completely new set of buyers, which props up prices even higher.

And all of this was started by just a good story about a better future. This is how perceptions become a reality. This is how momentum works, but it does not last forever.

San Diego-based StockTwits.com


