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Reality check
By John Authers
Published: December 3 2009 19:10 | Last updated: December 3 2009 19:10

Is this recovery real? And if not, would it make any difference?

The trade of financial economics has taken a bruising after the

many surprises of the past two years, but a more ancient discipline
is coming back into focus: philosophy. In the vanguard is George
Soros, one of history’s most successful hedge fund managers –
and someone who prefers to judge himself as a failed philosopher.

Philosophers have long wrestled with the concept of perception:

how the “real” world corresponds to our perceptions of it, or
whether it even makes sense to say there is something “real” out
there.

Most of us tend to dismiss such questions as sophistry. Soros, on the other hand, has wrestled with the problem
since he was a student. And he may have the last laugh, because he appears to have turned the philosophy of
reality into a way to make money.

Soros’s guiding principle, as outlined in his book*, concerns “reflexivity”: how our perceptions of the world, as
expressed through buying and selling, change the world itself. When markets become “reflexive”, they reflect flawed
perceptions rather than a prior “reality” – but the market’s version of “reality” is no less real because of that.

Soros’s key principles are first that “market prices always distort the underlying reality which they are supposed to
reflect”; and second, that “instead of playing a purely passive role in reflecting an underlying reality … markets also
have an active role: they can affect the so-called fundamen-tals they are supposed to reflect”.

Reflexive markets can turn into bubbles. And bubbles can turn into opportunities to make money for those like Soros,
who have the self-discipline to invest in an incipient bubble and get out before it bursts.

Armed with Soros’s insight, the question of whether we should believe in the current market rebound looks different.
Last year’s collapse rested on confidence. Oil prices, for instance, grew so high that they put pressure on the
economy and forced companies to change their output decisions.

However, this year, numerous market factors have reinforced an impression of a recovery. That, in turn, has made it
easier to do business and precipitate an “actual” recovery.

Markets had sold off so much that only a slight change in perception moved them dramatically. To make money this
year was to understand the market “reality” that investors’ perceptions would create, rather than focus on an
apparently separate “fundamental” reality, which followed macroeconomic rules that still saw evidence of high
unemployment and lingering bad debt.

Once oil prices and Chinese shares moved upwards, this was evidence the “real” world was recovering. Once credit
markets recovered, it became cheaper for companies to raise finance, and that in turn gave good reason to buy
equities – and to buy other credit, as it could now be seen there were buyers out there prepared to buy debt. In this
way, perceptions of reality led to a different reality.

If this really is an incipient bubble – and the fact it relies on artificially cheap money from the government certainly
reinforces that impression – how will we know when it has become a true bubble and when will it end?

Again, Soros has a theory. “Every bubble has two components: an underlying trend that prevails in reality and a
misconception relating to that trend,” he says. A boom and an eventual bust are set off “when a trend and a
misconception positively reinforce each other”.

Eventually, “market expectations become so far removed from reality that people are forced to recognise that a
misconception is involved”. As doubts set in, “a point is reached when the trend is reversed; it then becomes
self-reinforcing in the opposite direction”.

World stock markets peaked in 2007 after a sudden sell-off in the bond market. Bond investors decided the rosy
assumptions in other markets simply could not happen without higher inflation, and reacted accordingly. The trend

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was reversed. A long bear market turned into a savage sell-off once the commodity market went into reverse, again
collapsing under its contradictions, and then the bankruptcy of Lehman Brothers, the US investment bank,
administered a nasty dose of reality.

Some geopolitical event, or a corporate incident like Lehmans’, could bring this rally to an end. Otherwise, it is best
to look at the bond and foreign exchange (forex) markets. If forex traders revolt against the huge volume of extra
bonds being issued to fund the deficit, that could push up interest rates and end the rally. Or, similarly, if the run on
the dollar gets to the point where many countries feel their own currencies are overvalued, and therefore take action,
this rally could come to an end.

* The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means (PublicAffairs, US)

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