Investing For Booms And Busts

April 20, 2009

Does observer bias limit the value of investors' interpretations of asset prices?


All things pass our way again. My New Era Not articles published in Corporate Finance Review from 1997 to 2000 reviewed economic and market climates and the relative performance of stocks, bonds, cash and commodities for the most part since 1874. These works laid the foundation for Reflexive Asset Allocation (RAA, Figure 2) introduced in Fighting Your Grand Father's Wars, a presentation that I gave in 1998-2001.

Our grandfathers fought wars prior to 1946 that taught them to how to defend and advance asset values during inflationary booms/busts and deflationary booms/busts. Their biggest fear was a deflationary bust. Prior to 2008, 1998 was the worst year for hedged portfolios that were not prepared for a deflationary bust. Such busts are rare, which is why most portfolios are unhedged for them.

After the Russian debt default earlier in the month, on August 31, 1998, Treasury Secretary Robert Rubin told us we were facing "The worst global financial situation we've had in the last 50 years." He also said we were gazing into the abyss. Prior to 1998, there was little interest in hedging deflationary busts. Interest waned again after the debt bubble was re-blown with a fresh blast of air during the fall of 1998. The cure included a massive round of global interest rate cuts and a Federal Reserve-orchestrated bailout of Long Term Capital Management, a leveraged hedge fund that had wasted nearly $100 billion in capital, while threatening the financial system.

I started developing Reflexive Asset Allocation (RAA) after the near collapse of the financial system in 1998, but its roots extend back to 1988. RAA is a by-product of George Soros's book, "The Alchemy of Finance," which introduced his theory of reflexivity.[i] Since my first reading in 1989, I have tried to stop seeing asset prices as they should be. Mr. Soros teaches us to interpret asset prices for what they are likely to represent. He warns that observer bias limits the value of our interpretations because price extends beyond economics.

We Are Mr. Market

Reflexivity operates on the assumption that markets are often inefficient in pricing assets because financial markets cannot discount the future correctly. According to Mr. Soros, investors are both participants and observers of asset price discovery. Mr. Soros's best articulation of his behavioral investment theory was at the World Economy Laboratory Conference in Washington, D.C., on April 26, 1994, when he said of investors: "They do not merely discount the future; they help to shape it."

Recent fears of a deflationary bust are greater than they were in 1998. The time is ripe for revisiting reflexivity and its impact on asset allocation. Reflexivity is centered on the awareness that price discovery is not scientific because it is dependent upon active bids and offers of participants who are simultaneously observers and interpreters of market prices. The scientific method requires observers to be independent of their empirical evidence (independent and dependent variables). Investors never were and never will be independent observers.

If most investors were passive buyers and sellers, there would be little information embedded into asset prices. Ironically, this void would result in greater market inefficiency, not less. Reflexivity is a seminal concept for guiding financial management (asset modeling) and central bank policy (economic modeling) because it indentifies the dangers and unintended consequences derived from too much quantitative analysis. Since 2007, inefficient prices have enabled black swans to destroy black boxes (CDOs, MBSs, SIVs and the like), which in turn disabled our economy, consequently vaporizing credit/liquidity and breeding financial firm insolvencies.[ii]

Applying Reflexivity In Asset Management

Understanding reflexivity is easier for traders and tactical asset managers than it is for strict adherents to Modern Portfolio Theory (MPT) who are married to the efficient market hypothesis. Traders know that MPT is dependent on fresh supplies of cash that foster orderly and liquid markets, the Hyman Minsky principal.[iii]

MPT is a bust when panic reigns as it often has since 1920 (Figures 1 and 2).[iv] MPT's popularity is a product of the boom times from 1985 through 1999. Boom times have always been fueled by ample supplies of new credit (leverage). Credit-driven liquidity tightens bid/ask spreads, making it possible for observers to proclaim that markets are eternally efficient, until they are not (2000-2002 and 2007-2008).

All things pass our way again. Most MPT adherents have relied upon data inputs from market observations made after 1946. In the post-World War II era, deflation has been rare. There were a few mild instances of year-over-year (YOY) declines in consumer prices in 1949, 1950, 1954 and 1955.



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