Tuesday, May 20, 2008

A successful prophet of the markets

By John Authers
Published: May 19 2008 03:00 | Last updated: May 19 2008 03:00

This was a book that George Soros badly wanted to write. It is probably not what many of its readers expect to read. But it shows that in his deeper thinking about the way markets operate, Soros was several decades ahead of his time.

The New Paradigm for Financial Markets includes Soros' verdict on the credit crisis. He thinks, as has been widely reported, that it is the most severe since the 1930s, and that it marks the end of a 25-year "era of credit expansion based on the dollar as the international reserve currency".

He also offers some solutions, which centre on new regulation for markets, and how to avoid forced sales for US homeowners. A highly entertaining diary recounts his investment moves in the first three months of this year, culminating with the confusion surrounding the fire sale of Bear Stearns.

His insights are clear and concisely expressed. They are worth reading for anyone interested in the topic. But what is most interesting, and obviously engages Soros at an emotional level, is the idiosyncratic philosophy he has developed to explain the metaphysics of how markets work. Even before the emergence of the efficient markets hypothesis, which has dominated academic thinking on markets for at least three decades, Soros had devised his own theory to prove markets were not efficient. He acted on this philosophy as an investor with spectacularly successful results.

That philosophy derived from his undergraduate studies at the London School of Economics under Karl Popper. The "relationship between thinking and reality", Soros calls "reflexivity." It fills the book's centre in chapters which he admits many will find "heavy going". In markets, Soros says, participants' thinking plays a dual function: they try to understand the situation (the "cognitive function"), and to change it (the "manipulative function"). The two functions can interfere with each other; when they doso the market displays "reflexivity".

So an investor's misperception of reality can help to change that reality, begetting further misperceptions. When market actors' decisions affect outcomes, patterns emerge. If a lot of people are bullish about internet stockstheir price goes up. Soros used the theory to predict, and profit from, a series of "initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles". Each bubble "consists of a trend and a misconception that interact in a reflexive manner".

A key implication of this is that markets do not tend towards "equilibrium", as predicted by modern portfolio theory. And they will not move in the "random walk" promulgated by efficient markets theory, which holds that prices always incorporate all known information and so move randomly in response to new information.

This is important, as the architecture of modern capital markets depends on these theories.And it begins to look as though the credit crisis was the tipping point at which academics and practitioners decided a new paradigm was needed to replace the efficient markets hypothesis. Alternative theories borrow from experimental psychology, advanced mathematics and evolutionary biology and have been built in response to experience in the markets.

The theory of "adaptive markets" - that markets follow trends until they become overblown and then start building up other trends - seems to be gaining ground as an alternative paradigm. Soros' title is a bid for his own theory of reflexivity to become the new paradigm. What is fascinating is how much modern thinking is in line with the theory he developed decades ago.

How does it help explain the credit crisis? Soros believes that a "super bubble" has been formed as the result of a "long-term reflexive process" over the last 25 years. Its hallmarks include credit expansion (boosted by the belief that inflation has been vanquished), and a prevailing misconception, which Soros unsurprisingly blames on Ronald Reagan and Margaret Thatcher, that markets should be given free rein.

There have been numerous financial crises in this period. According to Soros, these "served as successful tests which reinforced the prevailing trend and the prevailing misconception". Thus the current crisis grows in severity because it marks "the turning point when both the trend and the misconception have become unsustainable".

Many will dislike Soros' politics. Others will find the book self-indulgent. He calls himself a "failed philosopher" and badly wants his theory to reach a broader public. It is hard to imagine it would have been published were he not so famous and successful. But his restless intellectual curiosity commands respect. So does his ability to foresee the debate in theoretical finance. He may have been a failed philosopher, but he was a successful prophet.

The writer is the FT's investment editor

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