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Business News/ Opinion / Columns/  Adani stocks have given us a case study in the theory of reflexivity

Adani stocks have given us a case study in the theory of reflexivity

Market prices can influence an asset’s fundamentals and cause instability as George Soros warned

Photo: Reuters

In a recent interview, filmmaker Anurag Kashyap said: “When the focus is totally on a film’s opening numbers, the film’s DNA changes." He was perhaps unknowingly channelling his inner George Soros while talking about his flop magnum opus Bombay Velvet.

George Soros, a hedge fund manager, believes in the theory of reflexivity. In the normal scheme of things, the fundamentals of an asset are expected to impact its market price. So, if the earnings of a stock are expected to go up, its market price goes up to account for that possibility. If real estate demand is expected to go up, home prices go up.

But this is something we all understand. Soros’ theory of reflexivity says something exactly the opposite. As he writes in The New Paradigm for Financial Markets: “The crux of the theory of reflexivity is not so obvious; it asserts that market prices can influence the fundamentals." This is also what Kashyap said. The kind of money a film is expected to earn (its price in a way) on its release impacts the kind of film being made (the fundamentals that is). That’s reflexivity, where the market price impacts the fundamentals.

Reflexivity shows up in all kinds of markets. A simple example is banks giving out home loans. As Soros writes: “Banks treat the value of the real estate as if it were independent of the banks’ willingness to lend against it." When banks are more than willing to give out home loans, it drives up housing prices, which leads to banks giving out more home loans, ultimately leading to a housing bubble and attracting a wave of speculators wanting to make a quick buck.

In that sense, housing prices (a market price) end up impacting the fundamentals of the housing market by making homes expensive or in technical terms increasing the value of the collateral. This dynamic was at the heart of the real estate boom in the first decade of this century across the Western world, leading to indiscriminate lending even to people who were in no position to repay. This ultimately led to such individuals defaulting and a huge housing bubble bursting and pulling down many economies with it.

In the recent past, the dynamic of market prices impacting fundamentals has been seen in the venture capital (VC)-backed startup space. Luke Burgis gives the example of the now defunct Theranos. As he writes in Wanting: “From 2003 to 2016 investors [venture capitalists] gave [Theranos]… more than $700 million… Theranos, peaked at a valuation of over $10 billion."

This brought reflexivity into play. The increasing valuation of Theranos and other startups “made new investors froth at the mouth to get into action". As Burgis writes about VC-backed startups: “New investors want in because other smart investors are already in, and investor demand for the company’s shares allows the company to tell a better story, which fuels even more investor demand." So, as the valuation of a startup (its market price) goes up, it gets more investors interested as the company is in a position to tell a better story about prospects of the business it’s in (its perceived fundamentals) and that gets even more newer investors interested.

Over the last year, the startup story has turned. With interest rates (a market price of money) going up, their business models (the fundamentals), which were supposed to make money far into the future, now need to do so sooner. That has led to cost control,with employees being fired to reduce cash burn.

Now, let’s consider the latest example of US-based Hindenburg Research releasing a negative report on the Adani Group on 24 January, making many allegations against the business group. The report said that “we have taken a short position in Adani Group Companies through U.S.-traded bonds."

The impact of this report pulled down the bond prices of the Adani Group in the US. It also led to a crash in stock prices of the Adani companies listed in India. The falling market prices have now impacted fundamentals. As Moody’s Investors Service said in a recent press release: “These adverse developments are likely to reduce the group’s ability to raise capital to fund committed capex or refinance maturing debt over the next 1-2 years."

This limits the Adani Group’s ability to fund its future projects by borrowing through the issuance of dollar bonds. A 6 February report in Mint says that the group “plans to trim its capital spending plans". This comes on the back of financial institutions like Standard Chartered, Citigroup’s wealth arm and Credit Suisse no longer accepting Adani Group bonds as collateral on margin loans.

Further, the S&P Dow Jones Indices decided to remove Adani Enterprises, the flagship company of the Adani Group, from its sustainability indices with effect from 7 February.

All in all, the falling stock and bond prices seem to have forced the group to make decisions it otherwise wouldn’t have. It has also prepaid loans worth $1.1 billion taken against pledged shares.

What this means is that investors and entrepreneurs, possibly in their need to be positive all the time, end up assuming that the future will be similar to the recent past. They need to remember what Soros says about reflexivity. They should bear in mind that “financial markets cannot predict economic downturns accurately," but “can cause them".

Vivek Kaul is the author of ‘Bad Money’.

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