Time

Tuesday, December 25, 2007

READING THE MIND OF MR. MARKET

George Soros believes that everyone's view of the world is "somehow flawed or distorted," and how Soros turned that realization into a powerful investment tool.

While struggling with philosophical questions, Soros made what he considered to be a major intellectual discovery:
"I came to the conclusion that basically all our views of the world are somehow flawed or distorted, and then I concentrated on the importance of this distortion in shaping events."

Applying that discovery to himself, Soros concluded: "I am fallible." This was not just an observation; it became his operational principle and overriding belief.

Most people agree that other people make mistakes. Most will admit to having made mistakes - in the past. But who will openly acknowledge that they are fallible while making a decision?
Very few, as Soros implies in his comment in the book, Soros on Soros, about his former partner, Jim Rogers (fund manager and author of The Investment Biker): "The big difference between Jim Rogers and me was that Jim thought that the prevailing view was always wrong, whereas I thought that we may be wrong also."

When Soros acts in the investment arena, he remains aware that he can be wrong, and is critical of his own thought processes. This gives him unparalleled mental flexibility and agility.

If, as Soros believed, everybody's view of the world is "somehow flawed or distorted," then our understanding of the world is necessarily imperfect and often wrong.

Soros turned his realization that people's understanding of reality is imperfect into a powerful investment tool. On those occasions when he could see what others could not - because they were blinded, for example, by their beliefs - he came into his element.

When he started the Quantum Fund he tested his theory by searching for developing market trends or sudden changes about to happen that nobody else had noticed.

He found one such trend change in the banking industry.
Heavily regulated since the 1930s, banks were seen as staid, steady, conservative and most of all boring investments. There was no future for a hotshot Wall Street analyst in the banking business.
Soros sensed this was about to change: the old-style managers were retiring and being replaced by new, aggressive youngsters with MBAs. This new management, he felt, would focus on the bottom line and shake up the industry.
In 1972, Soros published a report titled "The Case for Growth Banks," forecasting that bank shares were about to take off. "He recommended some of the better-managed banks. In time, bank stocks began to rise, and Soros garnered a 50% profit."

Where Buffett seeks to buy $1 for 40 or 50 cents, Soros is happy to pay $1, or even more, for $1 when he can see a change coming that will drive that dollar up to $2 or $3.

To Soros, our distorted perceptions are a factor in shaping events. As he puts it, "what beliefs do is alter facts" in a process he calls reflexivity, which he outlined in his book The Alchemy of Finance.

For some, like the trader Paul Tudor Jones, the book was "revolutionary"; it clarified events "that appeared so complex and so overwhelming," as he wrote in the foreword.

To most others, however, the book was impenetrable, even unreadable, and few people grasped the idea of reflexivity Soros was attempting to convey. Indeed, as Soros wrote in the preface of the paperback edition, "Judging by the public reaction...I have not been successful in demonstrating the significance of reflexivity. Only the first part of my argument - that the prevailing bias affects market prices - seems to have registered. The second part - that the prevailing bias can in certain circumstances also affect the so-called fundamentals and changes in market prices cause changes in market prices - seems to have gone unnoticed."

Changes in market prices cause changes in market prices? Sounds ridiculous.
But it's not. To give just one example, as stock prices go up, investors feel wealthier and spend more money. Company sales and profits rise as a result. Wall Street analysts point to these "improving fundamentals," and urge investors to buy. That sends stocks up further, making investors even wealthier, so they spend even more. And so on it goes. This is what Soros calls a "reflexive process" - a feedback loop: a change in stock prices has caused a change in company fundamentals which, in turn, justifies a further rise in stock prices. And so on.

You have no doubt heard of this particular reflexive process. Academics have written about it; even the Federal Reserve has issued a paper on it. It's known as "The Wealth Effect."

Reflexivity is a feedback loop: perceptions change facts; and facts change perceptions. As happened when the Thai baht collapsed in 1997. In July 1997 the Central Bank of Thailand let its currency float. The bank expected devaluation of around 20%; but by December the baht collapsed from 26 to the U.S. dollar to over 50, a fall of more than 50%.

The bank had figured out that the baht was "really worth" around 32 to the dollar. Which it may well have been according to theoretical models of currency valuation. What the bank failed to take into account was that floating the baht set in motion a self-reinforcing process of reflexivity that sent the currency into free-fall.

Thailand was one of the "Asian Tigers," a country that was developing rapidly and was seen to be following in Japan's footsteps. Fixed by the government to the U.S. dollar, the Thai baht was considered a stable currency. So international bankers were happy to lend Thai companies billions of U.S. dollars. And the Thais were happy to borrow them because U.S. dollar interest rates were lower.

When the currency collapsed, the value of the U.S. dollar debts companies had to repay suddenly exploded...when measured in baht. The fundamentals had changed.
Seeing this, investors dumped their Thai stocks. As they exited, foreigners converted their baht into dollars and took them home. The baht crumbled some more. More and more Thai companies looked like they would never be able to repay their debts. Both Thais and foreigners kept selling.

Thai companies cut back and sacked workers. Unemployment skyrocketed; workers had less to spend - and those who still had money to spend held onto it from fear of uncertainty. The Thai economy tanked...and the outlook for many large Thai companies, even those with no significant dollar debts, began to look more and more precarious.
As the baht fell, the Thai economy imploded - and the baht fell some more. A change in market prices had caused a change in market prices.

For Soros, reflexivity is the key to understanding the cycle of boom followed by bust. Indeed, he writes, "A boom/bust process occurs only when market prices...influence the so-called fundamentals that are supposed to be reflected in market prices."

His method is to look for situations where "Mr. Market's" perceptions diverge widely from the underlying reality. On those occasions when Soros can see a reflexive process taking hold of the market, he can be confident that the developing trend will continue for longer, and prices will move far higher (or lower) than most people using a standard analytical framework expect.
Soros applies his philosophy to identify a market trend in its early stages and position himself before the crowd catches on.

In 1969 a new financial vehicle, real estate investment trusts (REITs), attracted his attention. He wrote an analysis - widely circulated at the time - in which he predicted a "Four Act" reflexive boom/bust process that would send these new securities sky-high - before they collapsed.

Act I: As bank interest rates were high, REITs offered an attractive alternative to traditional sources of mortgage finance. As they caught on, Soros foresaw a rapid expansion of the number of REITs coming to market.

Act II: Soros expected that the creation of new REITs, and expansion of existing ones would pour floods of new money into the mortgage market, causing a housing boom. That would, in turn, increase the profitability of REITs and send the price of their trust units skyrocketing.

Act III: To quote from his report, "The self-reinforcing process will continue until mortgage trusts have captured a significant part of the construction loan market." As the housing boom slackened, real estate prices would fall, REITs would hold an increasing number of uncollectible mortgages - "and the banks will panic and demand that their lines of credit be paid off."

Act IV: As REIT earnings fall, there would be a shakeout in the industry...a collapse.
Since "the shakeout is a long time away," Soros advised there was plenty of time to profit from the boom part of the cycle. The only real danger he foresaw "is that the self-reinforcing process [Act II] would not get under way at all."

The cycle unfolded just as Soros had expected, and he made handsome profits as the boom progressed. Having turned his attention to other things, over a year later after REITs had already begun to decline, he came across his original report and "I decided to sell the group short more or less indiscriminately." His fund took another million dollars in profits out of the market.

Soros had applied reflexivity to make money on the way up and the way down.
To some, Soros's method may appear similar to trend-following. But trend-followers (especially chartists) normally wait for a trend to be confirmed before investing. When the trend-followers pile in (as in "Act II" of the REIT cycle) Soros is already there. Sometimes he would add to his positions as the trend-following behavior of the market increased the certainty of his convictions about the trend.

But how do you know when the trend is coming to an end? The average trend-follower can never be sure. Some get nervous as their profits build, often bailing out on a bull market correction. Others wait until a change in trend is confirmed - which only happens when prices have passed their highs and the bear market is under way.

But Soros's investment philosophy provides a framework for analyzing how events will unfold. So he can stay with the trend longer, and take far greater profits from it than most other investors. And, as in the REIT example, profit from both the boom and the bust.

Soros's theory of reflexivity is his explanation for Mr. Market's manic-depressive mood swings. In Soros's hands it becomes a method for identifying when the mood of the market is about to change, for enabling him to "read the mind of the market."

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