Quote of the Day: How Psychological Reflxivity Help Shape the Bubble Cycles

In a 2010 op-ED, market savant (and crony) George Soros explained the psychological "reflexive" dimensions of the bubble cycles. (bold mine)

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality I speak of far from equilibrium conditions. That is where we are now.

Second, financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified. I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921, but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever, and if the underlying reality remains unchanged, it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals. By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually, market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity, but they are the most spectacular.

In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting case where negative feedback is carried to its ultimate limit. Positive feedback has been largely assumed away by the prevailing dogma, and it deserves a lot more attention.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, “As long as the music is playing, you’ve got to get up and dance. We are still dancing.” Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

The simplest case of a purely financial bubble can be found in real estate. The trend that precipitates it is the availability of credit; the misconception that continues to recur in various forms is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship is reflexive. When credit becomes cheaper, activity picks up and real estate values rise. There are fewer defaults, credit performance improves, and lending standards are relaxed. So at the height of the boom, the amount of credit outstanding is at its peak, and a reversal precipitates false liquidation, depressing real estate values.

The bubble that led to the current financial crisis is much more complicated. The collapse of the subprime bubble in 2007 set off a chain reaction, much as an ordinary bomb sets off a nuclear explosion. I call it a superbubble. It has developed over a longer period of time, and it is composed of a number of simpler bubbles. What makes the superbubble so interesting is the role that the smaller bubbles have played in its development.

Any wonder why Mr Soros believes that the financial markets today has been bound for a "negative feedback"?

$10 Trillion of Negative Yielding Bonds, George Soros Bets Big on a Market Crash!

This is from my June 9 write up:

 

Negative yielding global bonds have reached $10 trillion says Fitch. This means that instead of borrowers paying lenders for the privileged to access someone else’s or the lender’s savings, negative yields means lenders are paying borrowers to borrow! Of course under the fractional reserve banking, lending is not a function of someone else's savings but from the central bank's digital press. 

Even more, any entity that owns a negative yielding instrument is guaranteed of losses. So the broadening of negative yields simply means that losses in the financial and economic system has been mounting! And all these for the sake of holding onto liquid instruments that ensures of the financing of spendthrift governments around the world. 

In short, negative yield is like a premium for the convenience yield. 

Think of what this will do to financial institutions, which are required to hold government debt as part of their Tier 1 Capital. 

And think of what this will do to pension and insurance funds. In order to match assets with liabilities these institutions are being forced out into the financial markets to gamble. And the yoke of the attendant risks from such speculative activities will be shouldered by depositors and pension beneficiaries…and eventually taxpayers and currency holders 

In Japan, because primary dealers are required to buy government bonds, Bank of Tokyo-Mitsubishi UFJ (BTMU) mulls to quit from such a role given the prospective losses. 

It has really been an upside down world that has been spawned by desperate central bankers. Negative yields have been designed to the shield from the mountain of accumulated debt, particularly government debt from imploding and setting off a crisis. 

And don’t forget given the globalization of financialization these negative yields have been transmitted to as partly carry trade or cross asset arbitrages. For instance, bond traders have sold negative instruments and have been piling into any bonds such as US treasuries with  positive yields. Some of these has been spilling over into emerging markets (which should include the Philippines) 

Well not everyone agrees that central bank magic will do its desired effect. Investing savants like Stanley Druckenmiller and Carl Icahn have bet recently big on the prospects of a market crash. 

Today, international media also reported George Soros have taken a sizeable position on a market crash. 

From the Business Insider (bold mine) 

Legendary investor George Soros is back to making big bets. 

Soros has returned to trading after a long hiatus, according to Gregory Zuckerman over at The Wall Street Journal. 

He has recently directed a series of large bearish bets, selling stocks and betting on gold, the report said. 

Soros, who ranks second on the list of the most successful hedge fund managers of all time, has spoken publicly about his concerns for the global economy. 

He recently said that China's financial system right now "eerily resembles what happened during the financial crisis in the US in 2007-08." 

And in Davos earlier in the year, he said that the world is running into something it doesn't know how to handle, and that he was betting against Asian currencies and commodity-linked economies. 

China later warned Soros against going to 'war' on its currency 

Soros stepped back from day-to-day trading some time ago, and his return to investing marks a turnaround. 

Scott Bessent had been the top investor at Soros Fund Management, but he left last year tolaunch his own fund, Key Square Group In January, Soros Fund Management named Ted Burdick as its news chief investment officer

Well you may interpret as my appeal to authority. Regardless, such unprecedented monetary-negative yield policies will come with big unintended very nasty consequences.

And because the world is interconnected and interdependent, rallying Philippine assets have been a consequence of the Developed Nation's negative interest rate and ZIRP policies for the rest. Yes the BSP has a negative real rates policy. Soros or no Soros.