What happened to Valeant Pharmaceuticals last week was all about reflexivity.
First popularised in his book “The Alchemy of Finance,” George Soros introduced the idea of reflexivity into markets in the late 1980s, which basically says that markets prices are what determine future market prices, not fundamentals or some asset’s underlying value.
In a note to clients over the weekend, Goldman Sachs’ David Kostin and the equity strategy team brought up the idea of reflexivity as it relates to last week’s price action in Valeant, when the stock fell about 35% in five days, including an intraday plunge of almost 40% last Wednesday.
“The recursive relationship that George Soros memorably described in “The Alchemy of Finance” was in full evidence this week as VRX shares plunged by 35%,” Kostin wrote.
“In the case of the equity market, reflexivity comes into play when some mechanism is triggered and participants’ bias shifts. Simply put, the so-called fundamentals that are supposed to determine market prices no longer matter. Instead, ‘market prices play a different role: They do not merely reflect the so-called fundamentals; they themselves become one of the fundamentals which shape the evolution of prices. This recursive relationship renders the evolution of prices indeterminate and the so-called equilibrium price irrelevant.'”
Back when Soros was writing about reflexivity, the prevailing wisdom said markets were efficient and would eventually converge at an equilibrium price, which is determined by evaluating the underlying value of a stock.
So if you walked through, say, a discounted cash flow analysis of a company, made a few assumptions about future earnings potential, and modelled some potential present and future valuations off this work, efficient markets would eventually give you the “right” price. Or rather, the market would, in time, back up your maths.
What Soros argued in his book, and which has now become an almost universally accepted element of how participants should at least be willing to think about markets, is that markets
aren’t efficient and often best-laid plans
don’t work out for investors, even over the long run.
But as Kostin notes, Soros not only put forth the idea that efficient markets don’t really work but added that current market conditions are what determine future market conditions. And while this sort of seems obvious and not at all like something worth getting worked up about — much less writing a whole book about — this idea was in fact a revolution in how people thought about market prices.
Price was no longer determined by some magical “right” price, but was determined by previous prices.
An example of how reflexivity works is in a merger where a company uses its shares as currency to acquire another company.
So let’s say shares of a given company trade at a price-to-earnings multiple of 15, roughly meaning that for every $US15 of share price investors get back $US1 of earnings. A certain analysis of this company might argue that the price-to-earnings multiple should be closer to 10, meaning that at 15 the stock is “overvalued” perhaps by as much as 50%.
But if you use the “overvalued” stock trading at a P/E of 16 to acquire another company — by, say, issuing 2 of your own shares for every 1 share of the company you’re buying to that company’s existing shareholders — then you’ve created a new currency that justifies its own price because of what it was able to get you. Namely, another company to call your own, acquired based on what some people would say are just bad assumptions or perhaps worse.
The point here, however, is that Valeant fell a lot last week and quickly and at least in the view of Kostin and his team, some of the reason Valeant shares fell is because Valeant shares were falling.
The firm notes that Valeant is owned about 22% by hedge funds and 5% of what Goldman calls “fundamental” hedge funds own the stock as a top 10 position (in which case the average weighting of Valeant is 10% of a fund’s portfolio), and so in short a lot of people had a lot riding on the stock continuing to go higher.
And then it didn’t, and so the stock was sold.
Perhaps the selling was done by these funds, or perhaps — as Valeant insinuated on its conference call Monday morning — the selling was doing by aggressive short-sellers the company thinks are merely serving their own ends. (This, of course, is a complicated morality claim often invoked by companies under fire, and which is either received as credible or not based on someone’s priors.)
What we do know is that Valeant shares sold off last week, were selling off modestly on Monday, and the company is facing a new reality, whether they or its investors think this is fair or not.