On George Soros and Valuations
June 26, 2010
The famous hedge fund manager, philanthropist and financial markets philosopher George Soros recently gave an important and wide-ranging speech on the crisis, his approach to financial markets and some suggestions on appropriate regulations of markets. Soros believes we have entered stage 2 of the crisis which is centred on the euro with Germany being the main protagonist (a theme also forcefully articulated by martin wolf).
Global financial markets were on life support in the aftermath of the Lehman bankruptcy, where sovereign credit was substituted for credit of financial institutions. This was the first step in a two step process which would, after the crisis had subsided, require a withdrawal of credit and restoration of macro-economic balance.
The first part of this manoeuvre has been successful, but the crisis is far from over and is entering its second stage where lack of confidence in sovereign credits is forcing premature reductions in budget deficits at a time when the economy and the banks have not yet fully recovered. This is liable to push the global economy into a double dip.
The crisis was caused by not just a failure of the market, but also a regulatory failure and most importantly a failure of the prevailing dogma about financial markets - the efficient market hypothesis and the rational expectations theory.
his approach to financial markets - enunciated in his 1987 book “the alchemy of finance” – can be summed up in two propositions: 1) that markets always reflect a distorted view of reality which at times can become quite pronounced, 2) financial markets are not only affected by the underlying fundamentals but also affect the fundamentals themselves thereby making the process of determining them uncertain.
The markets are subject to two countervailing forces – 1) a self-correcting trend which tends to bring markets and the underlying reality closer, and, 2) a self-reinforcing trend which causes markets to diverge from reality. These two forces cause the boom-bust phenomena.
Typically bubbles have an asymmetric shape – the boom is long and slow to start with, it then accelerates for a while eventually flattening out. the bust is short and steep reaching its climax in a financial crisis.
The simplest example of a purely financial bubble is in real estate – where the misconception that real estate values are independent of the availability of cheap credit grows as a self-reinforcing trend producing rapidly rising prices eventually leading to a peak in the amount of credit outstanding – and then the inevitable reversal causing a sharp drop in prices and a bust.
The prevailing trend in the “super-bubble” (which has comprised numerous mini-bubbles) we have seen grow over the last few decades years was the ever increasing use of credit and leverage in an environment where the prevailing belief was that markets are self-correcting and should be left to their own devices – encapsulated by the phrase “the magic of the marketplace” as coined by Ronald Reagan in the early eighties.
This prevailing trend was self-reinforced by the numerous actions by governments over the years to bail-out financial institutions and protect the economy, causing even greater use of credit and leverage which inflated the super-bubble further, eventually culminating in the financial crisis.
The implications of this approach in terms of regulating markets are: 1) since markets are bubble-prone authorities have to accept the responsibility to prevent bubbles from getting too big, 2) in addition to controlling money supply, the availability of credit needs to be controlled through margins and minimum capital requirements, 3) as markets are inherently unstable they pose systemic risks to the system which need to be monitored closely , and, 4) derivatives perform many useful functions but need to be regulated carefully to guard against their many hidden dangers , 5) “too-big-to-fail” banks need to be closely regulated to ensure that they are unlikely to fail by limits on leverage, use of deposits, separation of proprietary trading and compensation.
Soros provides a cogent analysis of market behaviour, bubbles and the cause of the financial crisis which can be a very useful framework in guiding our personal investment process. Firstly, those markets are almost always wrong in terms of reflecting - it’s just a question of degree! this is particularly important for long-term value investing – both from the perspective of deciding when to commence buying (i.e. when they are cheap based on long term value measures like the Shiller p/10e index) and when to start reducing exposure or stay in cash (when they are expensive based on the same measures). It is also extremely important to continuously assess where the market is in the boom-bust cycle and adjust your portfolio accordingly–even at the cost of being early – as capital protection at the time of the inevitable bust is of paramount importance to being able to stay in the investing game for a long period of time. i also agree with his assessment that the current focus on fiscal tightening is premature, and vastly increases the risk of a double-dip later this year or in early 2011. however, a significant market correction in the interim (of 20% or more?) is likely to bring out new support measures which will initially be centred on quantitative easing (i.e. a purchase of risk assets from the market) and subsequently a second round of fiscal spending (if we get a double-dip). This will likely fuel another playable bear market rally into the year-end and 2011!
On current market valuations:
I have attached a recent chart below from one of the most astute market analysts Andrew Smithers (who i have covered in prior emails) who thinks the market (despite the recent correction) is 50% overvalued:
“Andrew Smithers thinks that fair value for the S&P 500 is actually in the 700-750 range. Smithers, therefore, thinks the stock market is about 50% overvalued based on the current level of 1087. Smithers constructs his estimate in two ways: 1) the cyclically adjusted P/E ratio (measured against an average based on geometric mean rather than a simple arithmetic mean), and 2) something called "Tobin's Q," which is a measure of replacement value of the market.
Smithers' explanation for his valuation chart is as follows. It’s basically the idea is that near-term earnings are way too volatile to provide a meaningful read on the market's valuation at any given moment. Thus, to get a meaningful sense of valuation, you need to look at a fundamental measure that is more stable than quarterly earnings. The cyclically adjusted pe, which averages 10 years of earnings, and Tobin’s Q, which looks at assets, provide this. And as you can see in the chart, over the long haul, the market does tend to revert to the means”.
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