Saturday, November 29, 2008

Reflexivity revisited 0 comments

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Let's review the various perspectives about the relationship between stock prices and "business fundamentals" as most people understand it. First, there is the advice given by the Sage of Omaha about Mr Market being manic-depressive and that the prices he/she/it quotes can have a disconnect with underlying fundamentals. Then there is the typical technician's/efficient market theorist's view that price reflects underlying fundamentals, even though it might not seem so at the time to the outsider. And then there is George Soros, who advocates that market prices can actually actively influence fundamentals. The last view is known as reflexivity, a term coined by Soros.

Despite Soros' celebrity fund manager status, reflexivity has never really caught on in popular investment literature, partly because it does not really have mathematical grounding. It is more of a philosophy than anything else, in its recognition of the two-way feedback between price and fundamentals, instead of the traditional view that fundamentals drive prices. But in the aftermath (I hope) of this credit crisis, it deserves serious all-round consideration and recognition now.

First of all, by virtue of the fact that Soros was among the first to recognise the seriousness of this crisis, calling it the greatest financial crisis since the Great Depression, his market ideas and philosophy deserve special elevation. Now everybody knows the current crisis as .... yes, "the greatest financial crisis since the Great Depression". Talk about parrots. But more importantly, the mechanics and evolution of this financial crisis indeed has the feel of a price-induced death spiral about it.

The most obvious linkage is market confidence. There is nothing that unnerves the self-assured long-term "fundamentals-driven" investor more than to watch the market value (and his net worth) of his investment drop day by day; it has the effect of shaking his conviction to the point of changing his perspective from "Mr Market is wrong" to "Mr Market might know something". The same applies to the bond investor of course, who will be driven more by credit concerns than earnings concerns (bond investors also tend to believe in market efficiency more). This is all fine if the stock is trading on the secondary market and the business is self-sustaining without funding concerns, because the business doesn't really care what price it's worth according to Mr Market, as long as its suppliers and customers continue doing business with it. Operations-side partners tend to be less market-sensitive; however financial-side partners are hyper market-sensitive, and this is where declining market valuation can feed into faltering confidence. If the company is constantly dependent on financing cashflow (not necessarily from stock market or bond market) to sustain its operations, or if indeed (in the case of banks) market trust is integral to its business model, then the reflexivity effect is particularly influential. Indeed, in Soros' original illustration of the reflexivity effect, he highlighted the case of REITs, which often funded new property purchases through issue of new units and therefore depended heavily on high market prices of their units to purchase these new properties at above-average yields ..... sort of a Ponzi scheme in my opinion. Today, REITs face a different market confidence-related concern .... they have trouble rolling over their current debt.

Another linkage is the interaction between market valuation and regulatory requirements. For the current crisis, the most obvious example is the mark-to-market rule which requires financial institutions to mark their financial assets at current market prices; given the collapse of mortgage securities and almost every other kind of financial asset except Treasuries, banks and insurance companies have taken a severe hit on their balance sheets. Regulatory requirements (eg. Basel 2 accord) requiring them to be sufficiently liquid or solvent then force them to have to raise cash, either by issuing new shares or bonds, or deleveraging through selling assets on the open market; any such measures are undertaken at unfavourable prices and adds further to the deterioration in market confidence.

Although I have pointed out earlier that operational-side partners tend to be less market-sensitive than financial-side partners, they will eventually be affected if asset prices correct significantly across entire markets. This is what is happening now as the financial crisis spills over to the real economy. Corporate customers unable to obtain trade financing have difficulty paying for ship charters, so ship owners are hit. Retail customers unable to obtain easy home loans or auto loans stop buying homes and cars, while those that hold significant paper wealth have effectively had their net worth halved or more, hence retailers are hit together with their previously free-spending customers. This is the capital market-to-economy linkage that presents another facet of reflexivity.

Such a positive-feedback spiral can feed on itself in the way that panic does. What are "fundamentals"? At the end of the day, it is hugely dependent on confidence. Without confidence that the future can be better, consumers will not consume. Without assurance that future consumer demand will grow, businesses will not invest. The demand curve is actually heavily dependent on sentiment, security and other intangibles; demand is what generates growth; it IS the fundamentals.

That is why the government has to come in to intervene, the way Keynes advocated and the way Soros believes has to be to break the reflexive spiral. It has to inject confidence through being the capital provider of last resort, revise regulatory requirements (or at least ease them), and provide counter-cyclical demand. Those who believe in letting the markets cure themselves, such as the Austrian school, the market fundamentalists and even Jim Rogers, are just hallucinating. Especially for Jim Rogers, I cannot understand why he was working with George Soros for years but does not seem to understand the government's role in breaking this crisis?

Those who want to read further about reflexivity should read Soros' book "The Alchemy of Finance" (link to my book review) where he expounds on his pet theory in greater detail.




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