George Soros & Reflexivity

George Soros is one of history's most successful market speculators, and one of the world's richest men. Former Federal Reserve Chairman Paul Volcker wrote in 2003 in the foreword of Soros' book The Alchemy of Finance:

"George Soros has made his mark as an enormously successful speculator, wise enough to largely withdraw when still way ahead of the game. The bulk of his enormous winnings is now devoted to encouraging transitional and emerging nations to become 'open societies,' open not only in the sense of freedom of commerce but - more important - tolerant of new ideas and different modes of thinking and behavior."

Soros is best known as the man who broke the Bank of England. His bear-raid on the British pound in 1992 precipitated the collapse of the European monetary system. The Bank of England was trying to defend sterling's price against the German mark as part of its duties under the decades-old Bretton Woods Agreement. Soros took a very public position that the post-Cold War world had changed thanks to the inflationary effects of Germany's reunification, and that the traditional currency relationships would have to change, too. On Black Wednesday (September 16, 1992), Soros sold short more than $10 billion worth of pounds. Followed by a chain reaction of speculators who piled on after him, sterling was forced down in such a massive assault that the Bank of England was forced to withdraw the currency out of the European Exchange Rate Mechanism and to devalue the pound sterling. This resulted in the transfer of billions of pounds from Her Majesty's Treasury to Soros' coffers. Soros earned an estimated US$ 1.1 billion in the process.

The Times October 26, 1992, Monday quoted Soros as saying:

"Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell."

He's said to have done it again in the Asian currency crises of 1996 and 1998. In 1997, during the Asian financial crisis, then Malaysian Prime Minister Mahathir bin Mohamad accused Soros of using the wealth under his control to punish ASEAN for welcoming Myanmar as a member. Later, he called Soros a moron. Thai nationals have called Soros "an economic war criminal" who "sucks the blood from the people".

The central concept of Soros' philosophy is what he calls the theory of reflexivity. It is a profound and powerful model for identifying the dynamics of booms and busts. The theory of reflexivity is explained at length in Soros' books. But you can get a terrific quick-start introduction to it on his Web site, in the text of a speech he delivered at MIT in 1994. Soros summarizes the theory of reflexivity this way:

"...financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect."

When reflexivity comes into play, markets go into what Soros calls "dynamic disequilibrium." That means virtuous upside cycles that lead to bubbles and booms, and vicious downside cycles that lead to crises and crashes. Whether Soros is theoretically right or wrong on this issue, he certainly has the market credentials and proven track record to effectively maintain that his theory of reflexivity is practically relevant in the marketplace — at least for him. Soros has popularized the concepts of dynamic disequilibrium, static disequilibrium, and near-equilibrium conditions. Reflexivity is based in three main ideas:

1. Reflexivity is best observed under special conditions where investor bias grows and spreads throughout the investment arena. Examples of factors that may give rise to this bias include (a) equity leveraging or (b) the trend-following habits of speculators.
2. Reflexivity appears intermittently since it is most likely to be revealed under certain conditions; i.e., the equilibrium process's character is best considered in terms of probabilities.
3. Investors' observation of and participation in the capital markets may at times influence valuations AND fundamental conditions or outcomes.

The bust in Internet stocks can be interpreted through the theory of reflexivity. Young companies without earnings are critically dependent on the ability to raise money in financial markets. When their stock prices are rising, financing is assured and an important risk is eliminated -- the rising price itself makes the company more viable, which in turn leads to an even higher price, which makes the company more viable still. The same thing happens in reverse when stock prices decline. The risk of future financing increases, so the stock price falls further, which increases the risk even more, which causes further decline, and so on and so on, reflexively.

When you understand the theory of reflexivity, you can see how Soros employed it to pull off his most spectacular wins. And you can also see how his failure to employ it correctly led to his most spectacular losses.

During the stock market crash of October 19, 1987, since known as Black Monday, Soros became intensely bearish. He dumped S&P 500 futures on the opening the following day, thus personally contributing to its aftermath, Terrible Tuesday. Of course, the market recovered later in the day, and never again traded much lower. During the dotcom crash, Soros found technology stocks too hot to handle, and dumped them into the spring's Nasdaq crash -- the Composite Index now stands well above the panic lows.

Is the current US market in a state of dynamic disequilibrium?