George Soros and the Theory of Price Reflexivity

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Aug 09, 2011
Perception is reality. At least according to George Soros’ interpretation on price reflexivity that implies a self-reinforcing boom and bust pattern, i.e., prices do influence the fundamental and change expectations thereafter through price dynamics. We certainly wouldn’t like to relive the incoming train wreck of the subprime mortgages culminating with full speed. The recent precipitous 12-day drop of the Dow Jones certainly brings back the fear instinct in all of us. All the market needs now is a boost of confidence to reverse the trend.

Below is a good article on how the price reflexivity works. Key excerpt: “But if you want to make serious investment gains, then you need to look out for the odd occasions when markets get irrational. That’s when you win big, or lose big. Soros noted that for markets to get reflexive, you need two things: leverage and trend following”

See, What George Soros can teach you about gold and house prices.

But this is a theory that has stood me in good stead — a market theory developed by the mighty George Soros. And it’s one that has helped to make me serious cash when markets become irrational.

Today, I want to show you how this theory works using house prices.

George Soros and the reflexive market

The academics say there’s a fundamental value for any asset, and the market never strays far from that valuation. But of course that’s a lunatic proposal — the likes of George Soros would never have become a self-made billionaire by listening to clap-trap like that.

Soros studied at the London School of Economics during the early '50s. And it was then that he came up with his own theory about how markets work.

Soros realized that the fundamentals used to make a valuation change as investor perception changes.

During the mid-'90s, UK house prices started to go up. They started off cheap as we came out of the '90s recession.

As prices went up, perceptions started to change. This is how it happened:

Bank balance sheets got stronger and stronger. Bad loans on housing were almost non-existent during the late nineties and early noughties. That allowed the banks to loosen lending standards. Over the years, they moved from lending out three years' salary, right up to crazy multiples like seven, or eight times.

All the while, borrowers lucky enough to be in on the game bought more and bigger houses. Prices were chased up and all the while the banks' balance sheets got stronger and stronger.

Strong bank and personal balance sheets allowed punters to borrow monstrous amounts of money. In fact, self-certified mortgages didn’t require much more than some made-up numbers to get some fat loans.

And because banks made so much "risk-free" profit on mortgages, they trimmed back their margins. Effectively mortgage rates were slashed to the core — special discount deals and fixed rates put a skyrocket under prices.

You see how the fundamentals for valuing houses changed because of the bull market itself?

Of course you can’t ignore the fat hand of government in all of this. Government policies tend to favor home ownership. In the States, the government practically is the mortgage market; and most governments allow tax-free speculation on personal property. Government policy amplified the changing fundamentals.

A market that feeds back on itself like this is called a reflexive market. Let’s see how we can profit from it today.

(Extracts copied in verbatim)