DPAM "Themes" vom 18.09.2023
Unlike the efficient market hypothesis, the theory of reflexivity suggests that the beliefs of market participants can actively shape the markets themselves.
Let’s revisit George Soros’ seminal book and analyse the striking links to today's financial scene.
2023 is proving to be a pivotal year in many respects. Over 2023, financial markets are relearning many lessons in asset valuation under high uncertainty. Whether one was against or in favour of central bank large-scale asset purchases, the fact is that price discovery between 2009 and 2021 across asset classes was guided and influenced by the behaviour of central banks. Market makers in government bonds and credit operated with the comfort of having almost continuously a buyer of last resort on their side. As investors were pushed up the credit and risk curve, the momentum investment style thrived, alongside performances. The sky wasn’t the limit, as at times monetary impulses were propelled by fiscal impulses.
Over the past summer, the above musings pulled me back towards the seminal book, ‘The Alchemy of Finance’ – second print 1994 – authored by George Soros. I consider it almost as a treaty, a protocol in understanding how financial markets operate. It’s about the absence of equilibrium and certainty. George Soros is almost, for lack of a better word, philosophising about the continuous variable interaction (or lack thereof) between observed market trends (up, down, sideways), the prevailing biases of market participants, and the (public & private) economic and corporate fundamentals. I remember reading the book as a young market maker; I was intimidated by its complexity. I didn’t fully understand the messages George Soros was conveying. With age, and having experienced many stressed market conditions, high and low volatility episodes, recessions and expansions, my respect grew stronger in line with my understanding.
The book is built around the concept of reflexivity. Reflexivity states that what market participants believe about a market condition will influence that specific condition. Expectations of market participants shape market pricing, which in turn influences market expectations. Events do not move from outcome to outcome but from expectation to outcome to expectation.
The efficient market hypothesis (EMH) states that asset prices contain and reflect all available information. Given rational expectations (perfect insight), markets will optimally allocate land, labour, capital, and entrepreneurship. Soros debunks EMH and states that markets are inefficient, and market participants are irrational and biased. He describes that “the two-way feedback mechanism that is the hallmark of reflexivity can come into play at any time but is not true in the sense that it is at play all the time. In fact, in most situations, it is so feeble that it can be safely ignored. We may distinguish between near-equilibrium conditions where certain corrective mechanisms prevent perceptions and reality from drifting too far apart, and far-from-equilibrium conditions where a reflexive double-feedback mechanism is at work and there is no tendency for perceptions and reality to come close together without a significant change in the prevailing conditions…a change of regime”. The book describes reflexivity at work across equity, currency, and credit markets.
The prevailing bias of market participants over the past summer gave support to steady and rising equity markets. The prevailing bias in rates called for higher long-term rates as the Fed and ECB never let go of their tightening biases. The prevailing bias in credit is still positive, based on the perception that companies locked in cheap financing conditions for an average of 7 years before the FED started its hiking cycle. Additionally, current high short-term yields are a tailwind for cash-rich companies. Tightening credit spreads over the past few months and supportive equity and economic narratives all worked in the same direction. Present trends receive confirmation by their respective prevailing biases in a reflexive fashion. What could possibly represent a significant change in prevailing expectations? Are we in near-equilibrium or far-from-equilibrium conditions that could herald a destabilising regime shift?
Clearly, during 2022 and the first half of 2023, we went through a regime shift in monetary policy. The result was devastating as most asset classes repriced aggressively last year. In hindsight, markets ended 2021 in a far-from-equilibrium state.
Today, the prevailing bias is shifting from expectations of continued monetary constraints towards a pause characterised by variable lags before tentative easing is upon us. Moreover, fiscal policy cannot persist in full throttle mode. Fears of fiscal dominance experiments are waning as the share of interest expenses as a % of GDP is gently rising to levels that will become uncomfortable over the next 3 to 5 years. Expect fiscal policy to enter a phase of diminishing impact over 2025 and beyond.
For most of the summer, economic fundamental indicators supported soft landing narratives. And indeed, without any certainty, we detect feeble reflexivity potential across fixed income and currency markets. If one has the skill to select and invest in quality names across the fixed income sectors, from DM & EM government bonds to investment grade over high yield credit, long-term value can be locked in. For equity markets, we should be vigilant as the prevailing bias and observable trends have been highly positive for a few but less impressive for the majority of companies. Equity markets have embraced the winner-takes-all phenomenon. Yet, the steep increase in discount factors or cyclical economic uncertainty ahead has been affecting specific sectors. The dispersion in performance across equity sectors has been elevated in 2023, testament to the complexity in estimating its future path.
Returning to the book, The Alchemy of Finance, I advise delving into chapters 2, 3, and 4 that deal with reflexivity in the stock market, currency markets, and the credit and regulatory cycle. I recommend two or three readings of the approximately 40 pages as the subject matter discussed is complex.
Recognised trends and prevailing biases require inflection points to change direction. The prevailing bias in equity markets is partially incorporated across actual stock price evolution and underlying fundamentals, and is also expressed to some extent by the intensity of the divergence between them. Proper (fundamental) analysis does pay off, refuting the assertion that the market is always right. Soros replaces this ‘axiom’, often used by proponents of index solutions, with two others: “1. Markets are always biased in one direction or another. 2. Markets can influence the events that they anticipate. The combination of these two assertions explains why markets so often appear to anticipate events correctly”.
Reflexivity in currency markets is continuously present and inherently unstable. Currencies follow a wave pattern of under- and overvaluation.
Reflexivity in credit is expressed through a boom-and-bust sequence, a sequence that is asymmetrical. Soros focuses on the role of collateral and its quality. The link with the events unfolding in China and the related bust in the real estate sector springs to mind. The section on regulators, described as also being human and participants, is fresh and revealing. Regulators are not motivated by profit and loss but instead create rules and frameworks designed to prevent the last mishap, not the next one. Like currency markets, regulatory cycles come in waves. The length of the regulatory cycle tends to correlate with the credit cycle. This provides context for the potential impact of renewed capital adequacy regulation for the banking sector, the moment tightening of financial conditions could harm the credit cycle.
As central banks have retreated and markets are left to their own devices, I recommend revisiting a book written by a legendary investor that provides genuine insight into the complexities of financial markets. Moreover, ‘The Alchemy of Finance’ offers the reader a set of tools that can enhance their level of understanding. A better level of understanding leads to better investment results.
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