Reading the Mind of Mr. Market

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

In 1949 – having escaped from Soviet-occupied Hungary two years before – George Soros enrolled at the London School of Economics to study economics and international politics. The LSE was a hotbed of socialism, no different from most other universities at the time.

But the LSE was also home to two very unfashionable thinkers, free market economist Friedrich von Hayek and philosopher Karl Popper. Soros learnt from both, but Popper became his mentor and a major intellectual influence on his life.

Popper provided Soros with the intellectual framework that, later, evolved into both Soros’s investment philosophy and his investment method. In his student days, Soros’s aim was to become an academic, a philosopher of some kind. He began writing a book he called The Burden of Consciousness. Only when he realized he was merely regurgitating Popper’s philosophy did he put it aside and turn to a financial career. Ever since, he has viewed the financial markets as a laboratory where he could test his philosophical ideas.

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."

George Soros: "I Am Fallible."

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.

George Soros: "The Case for Growth Banks"

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. Through the book Soros also met Stanley Druckenmiller who sought him out after reading it, and eventually took over from Soros as manager of the Quantum Fund.

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."

George Soros: Where Perceptions Diverge from Reality

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."

Regards,

Mark Tier
for The Daily Reckoning
April 06, 2005

The above essay is taken from Mark Tier’s book, From Becoming Rich: The Wealth-Building Secrets of the World’s Master Investors Buffett, Icahn, Soros.

Mark Tier founded and edited (until 1991) the investment newsletter World Money Analyst, and is also the author of Understanding Inflation, The Nature of Market Cycles, and How To Get A Second Passport. His articles have appeared all around the world, in publications varied as Time, Reason and Business Traveler.

Seven years ago he adopted the wealth-building secrets of the world’s master investors, sold all his business interests and now lives solely from the returns on his investments.

Never get married to your investments, say the experts. When they don’t work out, dump them.

But we’ve never been a cad when it comes to our investments. Last week, as we were looking over some of our old investments, we found some stocks that we’ve been married to for years. But we hadn’t seen them in so long, we’d forgotten what they looked like. We’ve held WR Grace, for example, through boom, bust, bankruptcy, and then boom again. We only married the stock in the first place because we felt sorry for it. WR Grace was being hit with lawsuits for asbestos, as we recall, we figured the poor girl needed a little support. Then, she went Chapter 11. But it’s worked out. The company came out of bankruptcy and the stock went back up. We have no regrets.

We only bring this up to compare our own antique style of investing with today’s one-night-stand investment world. People don’t seem to believe in marriage anymore. When the going gets rough, investors get going somewhere else. Or, people merely think they can have more fun by fooling around. In California and Washington, D.C., says the Johannesburg newspaper, people are flipping houses as though they were changing their pants. Everybody’s trading up.

Almost nobody buys a stock for the dividends – few stocks have any to speak of. According to the press report, it sounds as though no one buys a house to live in either. Instead, they’re moving from one thing to the next, hoping to get rich on capital gains.

But, like getting a divorce, every change in investments involves expense. Brokers, movers, market makers, insiders, and sharpies – all need to earn a living. And they earn it on transactions. Over time, unless you get lucky, your capital gets worn down.

Besides, real investing takes time.

More news, from our team at The Rude Awakening…

————–

Tom Dyson, reporting from Baltimore:

"We incensed our Canadian readers when we sent them a special report titled ‘Backstabbed – The Great Canadian Double Cross." What does this have to do with prehistoric man in frilly cotton underwear?"

————–

Bill Bonner, with more views from South Africa…

*** We’re down here at the bottom of Africa looking at a business. It is a publishing business we began more than three years ago. In that time, the business went to being tiny, insignificant and money losing, to a small, but profitable, enterprise. Now, we are growing…and we hope to become more profitable as time goes by. But the project took years already…and considerable investment. It will take many more years for employees to learn their trades…to launch new products…to explore new markets…to make mistakes and recover from them.

But this is how a business really works. You do not make money overnight. Instead, you get something going, you invest money, you wait…and if you work hard, and are lucky, the thing pays off. Houses, too, take time. You have to live in them to get a return on your investment.

You may say, yes…but house prices are soaring. And, yes, you are right. As near as we can tell…the fastest, surest way to make money in America today is to find a partner who is penniless. Then, go to the nation’s hottest area and buy as many super-expensive houses as you can…with no-money-down. Make sure he signs as the buyer, not you. That way, if you’re wrong, you won’t lose anything. And if the housing bubble continues to expand…sell them all.

But don’t confuse this with investing. It’s pure speculation…a series of one-night stands that could be very enjoyable. The trouble is, most people don’t know what they’re doing. They begin to think there’s something magic about real estate that makes prices always go up. They begin to think they can’t lose. Then, when the bubble pops, they become the biggest losers of all.

But wait…a note from a friend who has followed bubble markets in real estate in Latin America:

"You’d expect them to crash. But in the years we’ve been following them [almost two decades] they never have. Prices soar when a place becomes popular. Then, they level off. We always expect a crash…but, so far, it hasn’t come."

So, you never know for sure. But the last 20 years has been a time of credit expansion everywhere. There have been a few busts in the United States – in New York and Texas, for example – but the general trend has been up. The Fed is still loose. The world is still booming (except Germany)…and prices are still going up.

So, go ahead…buy all the houses you want… make fools of yourselves. Get rich. Sleep around…and have a good time…

…while we old grumps look on, in envy and disgust.

*** "There’s a property bubble here in Jo’burg too," said a colleague yesterday. "At least that’s what people say. You can see it yourself. Just look out the window as you drive around. They’re putting up houses everywhere. I don’t know if it’s a bubble or not…but they’re building a lot of houses…"

*** Moody’s officially downgraded GM debt to junk status yesterday. As GM goes, so goes the nation – maybe. We wonder when America’s dollar…and America’s T-bonds will be regarded as junk.

*** This part of Johannesburg is so much like Texas. We work in office parks…and go to malls for dinner. We were hoping for something better.