Soros’ Alchemy – Chapter 4

Seth Klarman of Baupost wrote in a 1996 Letter that one should always be cognizant of whether seemingly different investments are actually the same bet in order to avoid risk of concentrated exposures. In other words, the task of risk management involves identifying (and if necessary, neutralizing) common risks underlying different portfolio holdings. One such "common denominator" risk that comes to mind (in today's yield-hungry environment) is the availability of credit and its impact on asset and collateral values, which in turn greatly influences returns available to investors holding different securities across the capital structure. Below are some musing on the topic of credit reflexivity / boom and bust cycles from George Soros, derived from his book Alchemy of Finance – Chapter 4: The Credit and Regulatory Cycle.

Macro, Intrinsic Value, Psychology, Risk

“…special affinity between reflexivity and credit. That is hardly surprising: credit depends on expectations; expectations involve bias; hence credit is one of the main avenues that permit bias to play a causal role in the course of events…Credit seems to be associated with a particular kind of reflexive pattern that is known as boom and bust. The pattern is asymmetrical: the boom is drawn out and accelerates gradually; the bust is sudden and often catastrophic…

I believe the asymmetry arises out of a reflexive connection between loan and collateral. In this context I give collateral a very broad definition: it will denote whatever determines the creditworthiness of a debtor, whether it is actually pledged or not. It may mean a piece of property or an expected future stream of income; in either case, it is something on which the lender is willing to place a value. Valuation is supposed to be a passive relationship in which the value reflects the underlying asset; but in this case it involves a positive act: a loan is made. The act of lending may affect the collateral value: that is the connection that gives rise to a reflexive process.”

“The act of lending usually stimulates economic activity. It enables the borrower to consume more than he would otherwise, or to invest in productive assets...By the same token, debt service has a depressing impact. Resources that would otherwise be devoted to consumption or the creation of a future stream of income are withdrawn. As the total amount of debt outstanding accumulates, the portion that has to be utilized for debt service increases."

“In the early stages of a reflexive process of credit expansion the amount of credit involved is relatively small so that its impact on collateral values is negligible. That is why the expansionary phase is slow to start with and credit remains soundly based at first. But as the amount of debt accumulates, total lending increases in importance and begins to have an appreciable effect on collateral values. The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy. By that time, collateral values have become greatly dependent on the stimulative effect of new lending and, as new lending fails to accelerate, collateral values begin to decline. The erosion of collateral values has a depressing effect on economic activity, which in turn reinforces the erosion of collateral values. Since the collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans, which in turn may make the decline more precipitous. That is the anatomy of a typical boom and bust.

Booms and busts are not symmetrical because, at the inception of a boom, both the volume of credit and the value of the collateral are at a minimum; at the time of the bust, both are at a maximum. But there is another factor at play. The liquidation of loans takes time; the faster it has to be accomplished, the greater the effect on the value of the collateral. In a bust, the reflexive interaction between loans and collateral becomes compressed within a very short time frame and the consequences can be catastrophic. It is the sudden liquidation of accumulated positions that gives a bust such a different shape from the preceding boom.

It can be seen that the boom/bust sequence is a particular variant of reflexivity. Booms can arise whenever there is a two-way connection between values and the act of valuation. The act of valuation takes many forms. In the stock market, it is equity that is valued; in banking, it is collateral.”

“Busts can be very disruptive, especially if the liquidation of collateral causes a sudden compression of credit. The consequences are so unpleasant that strenuous efforts are made to avoid them. The institution of central banking has evolved in a continuing attempt to prevent sudden, catastrophic contractions in credit. Since a panic is hard to arrest once it has started, prevention is best practiced in the expansionary phase. That is why the role of central banks has gradually expanded to include the regulation of the money supply. That is also why organized financial markets regulate the ratio of collateral to credit.”

“Financial history is best interpreted as a reflexive process in which there are two sets of participants instead of one: competitors and regulators…It is important to realize that the regulators are also participants. There is a natural tendency to regard them as superhuman beings who somehow stand outside and above the economic process and intervene only when the participants have made a mess of it. That is not the case. They also are human, all too human. They operate with imperfect understanding and their activities have unintended consequences.”

Soros’ Alchemy – Chapter 1, Part 3

Continuation in our series of portfolio management highlights from George Soros’ Alchemy of Finance – Chapter 1, Part 3: Soros introduces the theoretical foundations of reflexivity. Psychology, Intrinsic Value

“What makes the participants’ understanding imperfect is that their thinking affects the situation to which it relates…Although there is no reality independent of the participants' perception, there is a reality that is dependent on it. In other words, there is a sequence of events that actually occurs and that sequence reflects the participants' behavior. The actual course of events is likely to differ from the participants' expectations and the divergence can be taken as an indication of the participants' bias. Unfortunately, it can be taken only as an indication – not as the full measure of the bias because the actual course of events already incorporates the effects of the participants' thinking. Thus the participants' bias finds expression both in the divergence between outcome and expectations and in the actual course of events. A phenomenon that is partially observable and partially submerged in the course of events does not lend itself readily to scientific investigation. We can now appreciate why economists were so anxious to eliminate it from their theories. We shall make it the focal point of our investigation.”

“The connection between the participants' thinking and the situation in which they participate can be broken up into two functional relationships. I call the participants' efforts to understand the situation the cognitive or passive function and the impact of their thinking on the real world the participating or active function. In the cognitive function, the participants' perceptions depend on the situation; in the participating function, the situation is influenced by the participants' perceptions. It can be seen that the two functions work in opposite directions: in the cognitive function the independent variable is the situation; in the participating function it is the participants' thinking…

When both functions operate at the same time, they interfere with each other. Functions need an independent variable in order to produce a determinate result, but in this case the independent variable of one function is the dependent variable of the other. Instead of a determinate result, we have an interplay in which both the situation and the participants' views are dependent variables so that an initial change precipitates further changes both in the situation and in the participants' views. I call this interaction ‘reflexivity,’ using the word as the French do when they describe a verb whose subject and object are the same…

This is the theoretical foundation of my approach. The two recursive functions do not produce an equilibrium but a never-ending process of change…When a situation has thinking participants, the sequence of events does not lead directly from one set of facts to the next; rather, it connects facts to perceptions and perceptions to facts in a shoelace pattern. Thus, the concept of reflexivity yields a 'shoelace' theory of history.”

“Returning to economic theory, it can be argued that it is the participants' bias that renders the equilibrium position unattainable. The target toward which the adjustment process leads incorporates a bias, and the bias may shift in the process. When that happens, the process aims not at an equilibrium but at a moving target…

Equilibrium analysis eliminates historical change by assuming away the cognitive function. The supply and demand curves utilized by economic theory are expressions of the participating function only. The cognitive function is replaced by the assumption of perfect knowledge. If the cognitive function were operating, events in the marketplace could alter the shape of the demand and supply curves, and the equilibrium studied by economists need never be reached. How significant is the omission of the cognitive function? In other words, how significant is the distortion introduced by neglecting the participants' bias?

In microeconomic analysis, the distortion is negligible…When it comes to financial markets, the distortion is more serious. The participants' bias is an element in determining prices and no important market development leaves the participants' bias unaffected. The' search for an equilibrium price turns out to be a wild goose chase and theories about the equilibrium price can themselves become a fertile source of bias. To paraphrase J.P. Morgan, financial markets will continue to fluctuate. In trying to deal with macroeconomic developments, equilibrium analysis is totally inappropriate. Nothing could be further removed from reality than the assumption that participants base their decisions on perfect knowledge. People are groping to anticipate the future with the help of whatever guideposts they can establish. The outcome tends to diverge from expectations, leading to constantly changing expectations and constantly changing outcomes. The process is reflexive.”

Soros’ Alchemy – Chapter 1, Part 2

Continuation in our series of portfolio management highlights from George Soros’ Alchemy of Finance - Chapter 1, Part 2: Soros discusses the flaws of human psychology, how it complicates the task of investing in a marketplace of other thinking participants, why historical performance is not indicative of future results. He also explains why the term “alchemy” is in the title of the book. Psychology

“Natural scientists have one great advantage over participants: they deal with phenomena that occur independently of what anybody says or thinks about them. The phenomena belong to one universe, the scientists' statements to another. The phenomena then serve as an independent, objective criterion by which the truth or validity of scientific statements can be judged. Statements that correspond to the facts are true; those that do not are false. To the extent that the correspondence can be established, the scientist's understanding qualifies as knowledge…scientists have an objective criterion at their disposal.

By contrast, the situation to which the participants' thinking relates is not independently given: it is contingent on their own decisions. As an objective criterion for establishing the truth or validity of the participants' views, it is deficient…one can never be sure whether it is the expectation that corresponds to the subsequent event or the subsequent event that conforms to the expectation.

Thinking plays a dual role. On the one hand, participants seek to understand the situation in which they participate; on the other, their understanding serves as the basis of decisions which influence the course of events. The two roles interfere with each other…If the course of events were independent of the participants' decisions, the participants' understanding could equal that of a natural scientist; and if participants could base their decisions on knowledge, however provisional, the results of their actions would have a better chance of corresponding to their intentions. As it is, participants act on the basis of imperfect understanding and the course of events bears the imprint of that imperfection…

Participants have to deal with a situation that is contingent on their own decisions; their thinking constitutes an indispensable ingredient in that situation. Whether we treat it as a fact of a special kind or something other than a fact, the participants' thinking introduces an element of uncertainty into the subject matter…Perhaps the most outstanding example of the observer trying to impose his will on his subject matter is the attempt to convert base metal into gold. Alchemists struggled long and hard until they were finally persuaded to abandon their enterprise…”

Historical Performance

“A world of imperfect understanding does not lend itself to generalizations which can be used to explain and to predict specific events. The symmetry between explanation and prediction prevails only in the absence of thinking participants. Otherwise, predictions must always be conditioned on the participants' perceptions; thus they cannot have the finality which they enjoy in the-D-N model. On the other hand, past events are just as final as in the D-N model; thus, explanation turns out to be an easier task than prediction. Once we abandon the constraint that predictions and explanations are logically reversible, we can build a theoretical framework which is appropriate to the subject matter.”

This is why historical performance is not indicative of future results, and why performance chasing produces sub-optimal results. As Mark Twain said, “History doesn’t repeat itself, but it does rhyme.” It doesn’t repeat because markets are full of thinking participant forever shifting and adjusting their thinking, but it does rhyme because our fundamental psychological pathways remain unchanged over the span of centuries.

Soros’ Alchemy – Chapter 1, Part 1

Portfolio management highlights from George Soros’ Alchemy of Finance – Chapter 1: The Theory of Reflexivity. In part 1, Soros discusses the concept of price equilibrium, supply and demand, and why market prices fluctuate. Intrinsic Value

“The concept of an equilibrium is very useful. It allows us to focus on the final outcome rather than on the process that leads up to it. But the concept is also very deceptive…Equilibrium itself has rarely been observed in real life-market prices have a notorious habit of fluctuating. The process that can be observed is supposed to move toward an equilibrium. Why is it that the equilibrium is never reached? It is true that market participants adjust to market prices but they may be adjusting to a constantly moving target…

…modern economists resorted to an ingenious device: they insisted that the demand and supply curves should be taken as given…They argued that the task of economics is to study the relationship between supply and demand and not either by itself. Demand may be a suitable subject for psychologists, supply may be the province of engineers or management scientists; both are beyond the scope of economics. Therefore, both must be taken as given.

Yet, if we stop to ask what it means that the conditions of supply and demand are independently given, it is clear that an additional assumption has been introduced. Otherwise, where would those curves come from? We are dealing with an assumption disguised as a methodological device…

The shape of the supply and demand curves cannot be taken as independently given, because both of them incorporate the participants' expectations about events that are shaped by their own expectations.

Nowhere is the role of expectations more clearly visible than in financial markets. Buy and sell decisions are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions. To speak of supply and demand as if they were determined by forces that are independent of the market participants' expectations is quite misleading.

The very idea that events in the marketplace may affect the shape of the demand and supply curves seems incongruous to those who have been reared on classical economics. The demand and supply curves are supposed to determine the market price. If they were themselves subject to market influences, prices would cease to be uniquely determined. Instead of equilibrium, we would be left with fluctuating prices. This would be a devastating state of affairs. All the conclusions of economic theory would lose their relevance to the real world.”

“Anyone who trades in markets where prices are continuously changing knows that participants are very much influenced by market developments. Rising prices often attract buyers and vice versa. How could self-reinforcing trends persist if supply and demand curves were independent of market prices?”

“The theory of perfect competition could be defended by arguing that the trends we can observe in commodity and financial markets are merely temporary aberrations which will be eliminated in the long run by the ‘fundamental’ forces of supply and demand…The trouble with the argument is that there can be no assurance that ‘fundamental’ forces will correct ‘speculative’ excesses. It is just as possible that speculation will alter the supposedly fundamental conditions of supply and demand.”

“If we want to understand the real world, we must divert our gaze from a hypothetical final outcome and concentrate our attention on the process of change that we can observe all around us. This will require a radical shift in our thinking. A process of change is much more difficult to understand than a static equilibrium. We shall have to revise many of our preconceived ideas about the kind of understanding that is attainable and satisfy ourselves with conclusions that are far less definite than those that economic theory sought to provide.”

Soros' Alchemy - Preface & Intro

Dear Readers, apologies for the length of time since our last article. It’s been a busy year – got married, growing the business, grappling with a large position ruining otherwise healthy year-to-date performance – you know, all the usual life items. We have all experienced situations when the fundamentals of a business are moving in an expected direction, yet the price does not respond in kind. Many moons ago, we highlighted an interview with Stanley Druckenmiller in which he stated:

“…I focus my analysis on seeking to identify the factors that were strongly correlated to a stock’s price movement as opposed to looking at all the fundamentals. Frankly, even today, many analysts still don’t know what makes their particular stocks go up and down.”

“I never use valuation to time the market…Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction…The catalyst is liquidity…”

Very interesting indeed, but also incredibly vague. Thankfully, Druckenmiller’s zen master George Soros has written multiple books. And that’s where we went searching for more detailed explanations on how to gauge supply and demand, the driving forces behind market liquidity and price movement. Without further ado, portfolio management highlights from George Soros’ Alchemy of Finance – Preface & Introduction:

Psychology, Catalyst, Liquidity, Intrinsic Value

“The phenomena studied by social sciences, which include the financial markets, have thinking participants and this complicates matters…the participants views are inherently bias. Instead of a direct line leading from one set of conditions to the next one, there is a constant criss-crossing between the objective, observable conditions and the participant’s observations and vice versa: participants base their decisions not on objective conditions but on their interpretation of those conditions. This is an important point and it has far-reaching consequences. It introduces an element of indeterminacy which renders the subject matter less amendable to…generalizations, predictions, and explanations…”

“It is only in certain…special circumstances that the indeterminacy becomes significant. It comes into play when expectations about the future have a bearing on present behavior – which is the case in financial markets. But even there, some mechanism must be triggered for the participants’ bias to affect not only market prices but the so-called fundamentals which are supposed to determine market prices…My point is that there are occasions when the bias affects not only market prices but also the so-called fundamentals. This is when reflexivity becomes important. It does not happen all the time but when it does, market prices follow a different pattern…they do not merely reflect the so-called fundamentals; they themselves become one of the fundamentals which shape the evolution of prices. This recursive relationship renders the evolution of prices indeterminate and the so-called equilibrium price irrelevant.”

“Natural science studies events that consist of a sequence of facts. When events have thinking participants, the subject matter is no longer confined to facts but also includes the participants' perceptions. The chain of causation does not lead directly from fact to fact but from fact to perception and from perception to fact.”

“Economic theory tries to sidestep the issue by introducing the assumption of rational behavior. People are assumed to act by choosing the best of the available alternatives, but somehow the distinction between perceived alternatives and facts is assumed away. The result is a theoretical construction of great elegance that resembles natural science but does not resemble reality…It has little relevance to the real world in which people act on the basis of imperfect understanding…”

“The generally accepted view is that markets are always right – that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite point of view. I believe that market prices are always wrong in the sense that they present a biased view of the future. But distortion works in both directions: not only do market participants operate with a bias, but their bias can also influence the course of events. This may create the impression that markets anticipate future developments accurately, but in fact it is not present expectations that correspond to future events but future events that are shaped by present expectations. The participants' perceptions are inherently flawed, and there is a two-way connection between flawed perceptions and the actual course of events, which results in a lack of correspondence between the two. I call this two-way connection ‘reflexivity.’”

“Making an investment decision is like formulating a scientific hypothesis and submitting it to a practical test. The main difference is that the hypothesis that underlies an investment decision is intended to make money and not to establish a universally valid generalization. Both activities involve significant risk, and success brings a corresponding reward-monetary in one case and scientific in the other. Taking this view, it is possible to see financial markets as a laboratory for testing hypotheses, albeit not strictly scientific ones. The truth is, successful investing is a kind of alchemy. Most market participants do not view markets in this light. That means that they do not know what hypotheses are being tested…”

“…I did not play the financial markets according to a particular set of rules; I was always more interested in understanding the changes that occur in the rules of the game. I started with hypotheses relating to individual companies; with the passage of time my interests veered increasingly toward macroeconomic themes. This was due partly to the growth of the fund and partly to the growing instability of the macroeconomic environment.”

“Most of what I know is in the book, at least in theoretical form. I have not kept anything deliberately hidden. But the chain of reasoning operates in the opposite direction: I am not trying to explain how to use my approach to make money; rather, I am using my experiences in the financial markets to develop an approach to the study of historical processes in general and the present historical moment…If I did not believe that my investment activities can serve that purpose, I would not want to write about them. As long as I am actively engaged in business, I would be better off to keep them a trade secret. But I would value it much more highly than any business success if I could contribute to an understanding of the world in which we live or, better yet, if I could help to preserve the economic and political system that has allowed me to flourish as a participant.”

Macro

“Monetary and real phenomena are connected in a reflexive fashion; that is, they influence each other mutually. The reflexive relationship manifests itself most clearly in the use and abuse of credit. Loans are based on the lender's estimation of the borrower's ability to service his debt. The valuation of the collateral is supposed to be independent of the act of lending; but in actual fact the act of lending can affect the value of the collateral. This is true of the individual case and of the economy as a whole. Credit expansion stimulates the economy and enhances collateral values; the repayment or contraction of credit has a depressing influence both on the economy and on the valuation of the collateral.”

“Periodic busts have been so devastating that strenuous efforts have been made to prevent them. These efforts have led to the evolution of central banking and of other mechanisms for controlling credit and regulating economic activity. To understand the role of the regulators it must be realized that they are also participants: their understanding is inherently imperfect and their actions have unintended consequences.”