Housekeeping
Like always, it goes without saying that what I write in these posts is not financial advice. Also the opinions here are solely my own and they don’t represent the views of any company I might be affiliated with at the time of writing.
Blood on the streets
2022 financial markets have been brutal, regardless of where you tried to hide.
Stocks👇🏽
Bonds👇🏽
The drop in bond prices due to rising inflation and, therefore, higher interest rates has been particularly painful since investors tend to allocate money to bonds precisely to protect against the market drops we’ve seen lately. This hasn’t worked so well this time around, which has hurt large institutions with multi-asset portfolios.
Crypto👇🏽
Real Estate👇🏽
Every single asset class has taken a beating, with the exception of commodities👇🏽
Ok, but what about holding cash? Well…
With inflation near historical levels across the world, holding cash comes at a large cost: the certain loss of your purchasing power. Year-over-year inflation is high across the board:
🇺🇸 8.60%
🇪🇺 8.10%
🇬🇧 9.10%
🇨🇦 7.70%
🇦🇺 5.10%
🇲🇽 7.65%
🇧🇷 11.73%
🇮🇳 7.04%
🇯🇵 2.50% (this is actually quite high for Japan’s standards)
🇰🇷 5.40%
Investors are trapped between a rock and a hard place. This is quite the U-turn from the irrational exuberance that was rampant during early 2021.
At one point or another, financial markets tend to humble us all.
But, has the value of almost every asset really dropped as much as prices seem to indicate? How is it possible that there’s such a huge divergence in value in the span of just a few months? Read on for one possible explanation…
Financial alchemy
There is an agreed upon maxim in value investing and academic circles:
An asset’s intrinsic value is the present value of its future cash flows. And even though it might fluctuate due to the market’s irrationality, the price of an asset will eventually always reflect its intrinsic value.
Warren Buffett, Charlie Munger, Peter Lynch, Terry Smith, Bill Ackman, Seth Klarman, and various other incredibly successful investors agree with the above to some extent.
Soros calls bullshit 💩
Before George Soros was busy being the Antichrist he was one of the world’s most renowned investors.
I would encourage you to pick up The Alchemy of Finance if you ever get a chance. It can get quite heavy at first, but it’s an incredible attempt from a practitioner at explaining what are the main factors that drive financial markets. Below are some of my main takeaways.
💡 Natural Sciences vs Social Sciences
A natural science, like physics, is fundamentally different from a social science, such as economics and financial markets.
The outcomes in natural sciences are driven by the facts, whereas the outcomes in social sciences are driven by both the facts and thinking participants.
This makes it extremely hard to make accurate predictions in financial markets, since not only do you have to accurately analyze the facts, but also what are the expectations of thinking participants. There is both a cognitive function and a participating function at play.
♻️ Reflexivity
This brings us to one of Soros’ biggest concepts: reflexivity.
Thinking participants, such as investors/traders in financial markets, have an imperfect understanding of the world. And they use this imperfect understanding to formulate their views of the world and make predictions. These become their expectations.
Their expectations in turn end up having an effect on the world. There is a strong feedback loop that reinforces views and intensifies trends. Importantly, these feedback loops can actually influence reality beyond market prices by driving certain behaviors, such as irresponsible borrowing, for example.
“The participants’ views influence the course of events and the course of events influence the participants’ views.” - George Soros.
This effect permeates financial markets. Which leads us to…
🎢 The Boom-Bust Model
The chart above is very popular, and it clearly illustrates how Soros believes markets function. While academics would say prices reflect fundamentals, Soros believes prices are driven by self-reinforcing trends.
These trends are started by both facts (fundamentals) and participants’ perceptions, and then exacerbated by strong feedback loops. When fundamentals are rosy, participants look at this and formulate rosy views, which then affects the real world in a positive way, and on, and on. This is the boom 🥳
At one point during the trend, after it has extended way beyond sensible levels, participants will recognize that the facts don’t justify current levels. This leads to a sharp turn, an inflection point, and the direction of the trend changes with participants’ views and expectations reinforcing the new downtrend. At one point, participants become forced sellers when the excesses of the boom unravel. This is the bust 💀
Just as booms can reach irrational levels, so can busts. This can take a large emotional toll on investors that try to catch inflection points. Both the booms and the busts tend to overextend beyond what many would call fundamental levels. According to Soros, we’re always swinging from one extreme of the pendulum to the next.
Again, one of the most important points to highlight is that these booms and busts can, by their strong effects on participants, fundamentally alter the world.
🚧 The Brink
A theory mentioned briefly by Soros is that of the “brink” model. Sometimes economic catastrophes are avoided because movements in the market tip off participants and policymakers of the existence of this risk, which leads participants to alter the economic fundamentals and bring the system back from the brink. Basically, markets reflect expectations that can fail to materialize precisely because markets reflected them, allowing participants to course correct. Maybe I’m just a nerd, but to me this is a fascinating idea, and a precarious situation for all of us if true.
Worryingly, whether we come back from the brink depends on some key participants (policymakers, central bankers, regulators) interpreting market signals correctly and then choosing the right medicine. Looking at the world today, it seems to me that policymakers and central bankers are not on the hottest decision-making streak.
Thanks for reading! Hope you enjoyed and found the content interesting! Until next time!