QCM NexusOne Insight # 10

OCTOBER 2025

Aref Karim - Ershadul Haq - Raami Karim

FEEDBACK LOOPS IN MARKETS

HOW INVESTORS REINFORCE TRENDS, REVERSALS AND VOLATILITY

Markets as Mirrors

Markets are often described as mechanisms for price discovery. In theory, they reflect fundamentals: earnings, interest rates, supply and demand. But in practice, they also reflect something else –- the behaviour and positioning of market participants.

When enough market participants act on the same signals, stories, or fears, their collective behaviour reshapes the very prices they are reacting to. This creates feedback loops –– patterns where cause and effect blur, and today’s market action influences tomorrow’s moves in self-reinforcing cycles. Understanding these loops is critical, because they drive some of the most powerful moves in markets –– both up and down.

Positive Feedback: Riding the Wave

Positive feedback loops amplify existing trends. A small move attracts attention, more investors join, and the trend strengthens:

-  Momentum chasing: Rising prices attract inflows, which push prices higher, attracting still more inflows creating a cycle that drives valuations sharply upward.

-   Narrative reinforcement: Press and media coverage of rising markets fuel optimism, leading to further buying and perpetuating the upward momentum among eager investors.

-   Leverage cycles: Higher prices improve collateral values, enabling more borrowing and further buying, fuelling momentum even more.

These loops can be immensely profitable — until they reach extremes. Asset bubbles, from dot-com stocks to housing, are classic examples of positive feedback at work. When exuberance overtakes fundamentals, prices can disconnect sharply from underlying value. The longer the cycle persists, the more vulnerable markets become to sudden corrections or crashes. Ultimately, the unwinding of these feedback loops can be just as dramatic as their ascent, often leaving significant losses in their wake.

Negative Feedback: Stabilising Force

Not all feedback is destabilising. Negative feedback loops counterbalance extremes and restore equilibrium:  

-  Contrarian action: Falling prices attract contrarian or value buyers, halting declines. These actions can help stabilise markets by providing a floor under falling assets.

-  Risk limits: Portfolio managers de-lever when volatility spikes, reducing exposure and calming markets, which helps prevent further instability and losses.
-  Arbitrage: Dislocations attract capital that restores balance, like relative-value traders stepping in to exploit price inefficiencies and normalise markets.

Without these stabilisers, markets would spiral to chaos far more often. Negative feedback is why most volatility shocks eventually subside — though not always gently. These balancing mechanisms are essential for maintaining orderly markets and helping to protect portfolios from the worst effects of extreme price swings.

Reflexivity: Shaping Fundamentals

Sometimes feedback loops go beyond prices and alter fundamentals themselves. George Soros, the hedge fund manager, called this reflexivity.  And ‘the man who broke the BOE’, or nearly, by shorting the sterling in 1992 – believed in the idea that perception can change reality.

Consider the following:

- Credit markets: Rising bond prices reduce yields, making it cheaper for companies to borrow, which boosts investment and growth — justifying even higher prices.

- Currencies: A strong exchange rate attracts capital inflows, which further strengthens the currency.

- Equities: Rising stock prices improve corporate sentiment and hiring, supporting economic momentum.

In these cases, the loop is not just market psychology. It becomes economic reality. The feedback between prices and fundamentals can set off self-reinforcing cycles, where initial moves drive further changes in the real economy, amplifying the original trend. As a result, what begins as sentiment-driven market action can reshape corporate behaviour, investment decisions, and even broader economic outcomes.

Feedback Loops and Volatility

Feedback loops also explain why volatility clusters. When markets fall sharply, selling pressure begets more selling: stop-losses trigger, margin calls rise, risk models force de-risking. Each wave reinforces the next. Conversely, in calm markets, low volatility encourages leverage, tighter risk spreads, and complacency — which eventually set the stage for sharp corrections.

The cycle feeds on itself, until a new equilibrium is found.

Why Feedback Loops Matter

For market participants, ignoring feedback dynamics can be risky:

-Misreading persistence: Underestimating how long a positive feedback loop (like momentum) can run, often resulting in missed opportunities or premature exits from strong trends.

-Getting whipsawed: Entering late in the cycle, only to be caught in the reversal. This often leads to losses and frustration as positions are exited just as the trend resumes in the original direction.

-Overestimating fundamentals: Assuming prices reflect only intrinsic value, not collective positioning or market dynamics.

-Underestimating contagion: A loop in one market (say, credit) can spill into others (equities, FX), triggering broader instability across financial systems.

By recognising loops, market participants can better contextualise moves: is this strength fundamental, or self-reinforcing? Is this weakness permanent, or driven by temporary selling pressure?

Systematic Macro and Feedback Awareness

Systematic macro strategies are not immune to feedback loops — but they are designed to detect, respond, and adapt.

- Trend models harness positive feedback by systematically participating in momentum.

- Mean-reversion models exploit overshoots created by self-reinforcing moves.

- Risk overlays cut exposure when feedback loops accelerate volatility, reducing drawdowns.

- Diversification ensures that one loop doesn’t dominate the entire portfolio.

Rather than trying to predict loops, systematic macro builds frameworks that navigate them consistently.

NexusOne Insight: Navigating Reflexive Markets

At NexusOne, we accept that markets are not linear or purely rational. They are reflexive, dynamic systems where feedback loops drive much of the action.

- Our momentum models capture persistent trends while preparing for reversals.

-  And our mean-reversion models look to capture those reversals from overshoots

-  We scale risk dynamically as volatility feedback builds.

-  We diversify across asset classes, so no single loop overwhelms the portfolio.

Rather than fighting feedback dynamics, we engineer strategies built to work within them –– because in markets, as in nature, feedback is not a flaw; it is the very engine that drives the system.

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For informational purposes only. Not investment advice or an offer to invest.