Framework

GLOBAL MACRO FORECASTING FRAMEWORK AND THOUGHT PROCESSES

Purpose:

The purpose of this framework is to create a viable framework to forecast global macro economy/investments. We have built this framework based on the Theory of Reflexivity, which was applied and explored by the renowned macro trader George Soros. We humbly admit our lack of understanding of the world and that may prohibit us from developing certain methodologies or frameworks applicable throughout the time history. It should be noted that the paper is based on The Alchemy of Finance and our own empirical observations. Not enough real-time experiments have been done to prove the observations. Investors must not view this paper as investment recommendations or any financial advice, but for educational and informational purposes only.

Concepts and Thought Processes:

Theory of Reflexivity is defined as “In situations that have thinking participants, there is a two-way interaction between the participants’ thinking and the situation in which they participate. The two functions can interfere with each other by rendering what is supposed to be given, contingent” (Soros 2). We call this reflexive relationship between two different factors, the reflexive link, and we have denoted a reflexive link as <—>. We have also summarized the concepts and thought processes as following.

M represents current market conditions and M1 represents expected future market conditions. H represents future economic conditions based on economic theories. E represents confirming positive and negative events, F, fundamentals, S, market participants’ sentiment, and T, time course of developments. Each factor will be further characterized following the charts.

We have separated the framework into two different phases, the regular phase and the special phase, to explain two different types of environments of financial markets. The switch from the regular phase to the special phase usually represents an inflection point at a bottom or at a peak.

Regular Phase

During the regular phase, M, the current market conditions/pricing is formulated by E, F, S, M1. The M, E, F, S and M1 could be inter-reflexive with each other, but they don’t have to be inter-reflexive all at the same time; sometimes several factors are not reflexive with each other and reflexive links break apart. It is important to note that based on the definition of the Theory of Reflexivity, any reflexive relationships require to involve at least one cognitive function, which is embedded in both S and M1.

Regular Phase

It is very important to note that during the regular phase, we have discovered that the feedback loop between F and H could be blocked. H is objective and theory based future economic conditions, therefore thinking participants cannot alter H based on their cognitive functions. The blocked feedback loop is usually taken advantage of by fundamental weaknesses of human nature, such as greed and fear. Major dislocations could incur and are usually followed by volatile reverses during the special phase.

Special Phase

A special phase usually happens when inflection points are reached or close to be reached or right after the inflection points. It is important to note that during the special phase, the feedback loop between F and M1 (M1 and H become the same point during the Special Phase and cognitive function becomes embedded within M1(H)) is unblocked, and F and M1(H) start to be reflexive with each other. Due to the previous blocked feedback, practitioners could get surprised by the suddenly self-reinforcing and usually negative feedback loop between F and M1(H), which might lead to potentially big losses.

Special Phase

Reflexive Links:

  • Reflexive links are formed when two factors are self-reinforcing; reflexive links are broken when two factors are self-correcting. Two factors do not have to be self-reinforcing or self-correcting. In other words, they can be neutral with each other.
  • The degree of intensity of reflexive links between two factors may vary.
  • Reflexive links between different factors sometimes have sequences and do not happen at the same time.

F: Fundamentals

  • The construction of the universe of fundamentals has been well profiled by George Soros in The Alchemy of Finance (Soros 74-83). However, as he expressed in the book and we agree as well, the “fundamentals” is a complex puzzle, which could include more than what we have categorized or analyzed, i.e. earnings per share (Soros 57).
  • Within the universe of fundamentals, different fundamental factors may or may not have reflexive relationship with each other.
  • It’s important to note that the fundamentals of an economy are subject to economic laws, but may not be reflective of the laws in the short term and sometimes not even in the long term, as the feedback loop could be blocked as depicted in the graph; however the trend eventually becomes unsustainable, the reflexive links break apart and the regular phase switches to the special phase.

E: Events

  • We categorize events into positive confirming, negative confirming, positive disconfirming, negative disconfirming events (i.e. a positive confirming event indicates that the event confirms the existing feedback loop and helps to push the market price to go up) and neutral events. Events could also serve as a trigger for a positive or a negative feedback loop.
  • It is important to note that we view regulatory participants, such as a central bank, as one of the most important market participants; a policy driven event could be a very powerful positive or negative, confirming or disconfirming event.
  • One of the most important goals of corporate-level activism is participating in the event creation process, which could trigger a positive or negative feedback loop between F, S, M, M1, and T in favor of the market participant.

 S: Sentiment

  • Sentiment usually serves as an amplifier of a feedback loop between aforementioned factors. In other words, sentiment usually feeds an existing trend.
  • Sentiment levels can usually be quantified and analyzed by technical analysis; sentiment levels can also be qualified by biased opinions of market participants expressed on various media formats.
  • Occasionally, extreme levels of sentiment serve as indicators preceding disconfirming positive or negative events that improve or deteriorate the fundamentals, F; those disconfirming positive or negative events usually can reshape the market conditions, M, despite the fact that the expectations M1 might not have changed much. Those indicators are usually inflection points to buy low or sell high.

M: Current Market Conditions

  • The current market condition itself could reshape any other factors via cognitive functions, S or/and M1 within the framework even though the market condition is formulated by the other factors at the same time.

M1: Expectations of Future Market Conditions

  • The expectations of the future market conditions can be reflexive with any other factors within the framework even though itself is merely a projection of the future but not the future itself.

H: Future Theory Based Economic Conditions

  • We argue that future economic conditions are subject to the fundamental laws of economic theories.
  • In the regular phase, we have discovered that the current fundamentals might not be subject to the theory based future economic conditions, even if sometimes they contradict each other as thinking participants cannot alter H based on their cognitive functions.
  • In the special phase, we argue that the current fundamentals F are reflexive with the theory based economic conditions, as the feedback loop is unblocked. In addition, the current fundamentals F subject to theory based economic conditions during the special phase is inter-reflexive with other factors; if they contradict what the E, S, M and M1 currently indicate, a reversal of the previous feedback loop might happen. In such case, the intensity of reflexive links between the factors get particularly strong. The regulatory forces trying to create disconfirming positive events may very likely fail due to the intensity of those reflexive links.

T: Time Course of Developments

  • Time itself is objective and not reflexive with any factors; however the time course of developments could be reflexive and self-reinforcing with the M1, expectations during the regular phase; the time course of developments is usually self-correcting with the M1(H) during the special phase.
  • The time course of developments represents probably the single biggest uncertainty in the framework, yet the characteristics of which are under-recognized by majority of the market participants.
  • The instruments/strategies that are against the time factor such as buying call and put options contain additional uncertainties, but are compensated by volatility sometimes. Investors shall be aware of the alterations of T, due to its reflexive relationship with expectations, M1.

Reflexivity of Reflexivity

If Theory of Reflexivity becomes widely popular and applied knowledge, we argue that due to the nature of the theory, Theory of Reflexivity could become less useful in a way that the theory starts to reshape itself; thus, the theory could become less useful in related to predicting the continuous next current market condition, which serves as a proxy for the future in the financial markets.

A Real-Time Example

This was written by the author of this paper on his blog (ReflexiveProphecy.com) back in June 2015 by utilizing the framework, particularly the Regular Phase detailed in the paper:

“We don’t think S&P will close in year-end with a large loss as we think the markets continue to expect that as long as the Fed does not hike the rates in a fast pace, the economy will not be in a terrible shape. The expectations have reshaped and will reshape the reality. The logic flow will basically be and has been in this year: the economy gets stronger, the Fed accelerates the timing of the rate hike, the dollar gets stronger, the market has a small correction, the economic stats come in weaker, the Fed decelerates the timing of the rate hike and the dollar gets weaker. Because of this back-and-forth process, we expect the rate hike likely to happen in December 2015, later than the markets are expecting to happen in September 2015.” -https://reflexiveprophecy.com/2015/06/01/update-note-sp-neutral-this-year/

Dollar Index

Source: Stockcharts.com

Rate Hikes

Other Thoughts

The framework is created not to defy the uncertainties and probabilities as part of the nature but to contribute to the forecasting and thought processes of the global macro world as an under-discussed and complex topic. We have also discovered that the framework not only applies to the finance world but also applies to predicting and reshaping certain future life conditions; however that is not within the range of discussion in this paper.

Reference:

Soros, George. The Alchemy of Finance. Hoboken, New Jersey: John Wiley & Sons, 2003. Print.

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