My Diary 446 --- May the Force with us; The Theory of Reflexivi

My Diary 446 --- John Maynard Keynes; The Theory of Reflexivity

 

October 9, 2008

Money market spreads in the US remain extreme and most are still widening. While this situation persists, equity markets will likely keep falling. 14,000 is the next target on the HSI. Sector wise, commodity markets remain in free-fall. While this situation persists, the deep cyclicals (Steel, Non-ferrous metals, Shipping, Coal, Oil & Gas, and Cement etc) will likely remain at the epicenter of market weakness here in HK.

There are two questions to be answered: 1) Do equities still look cheap?  Not until the negative feedback loop is interrupted. And Because of government intervention, valuation does not matter at all right now. So 2) when will it end? I don't know, but no other quote could be more applicable than John Maynard Keynes: 'the market can stay irrational longer than you can stay solvent. Or remember that Japan, for instance, saw the bottom in mid 2003, after 20 years in purgatory.

If you believe in Sir John Keynes, as I do, governments should now go for broke if the Global Coordinated Cut plan does not put in a floor... which means deploy anything and everything. Open the briefcase and hit the big red button... quantitative easing, market closures, bank nationalizations, a sovereign guarantee of G8 inter-bank transactions... you name it.  The sovereign involvement in the crisis is deep enough that, at this point, and if it doesn't work, the outcome is awful, but one can argue that this outcome is no different than the outcome of inaction. So with the G8 Summit, imagine for yourself…Wish the Force with us.

Oversea Market Review

Overnight, the Fed and the ECB led a group of leading central banks in a coordinated 50bp rate cut. Their shared communiqué cited a decline in inflation risk and an accompanying increase in growth risk stemming from the financial crisis. The action was limited to developed-economy central banks, including those of the US, Canada, the Euro area, the UK, Switzerland and Sweden. China’s PBoC also separately cut rates 27bp for the second time in three weeks.

Regardless, global equities still declined 3.5% as stocks around the world continued to fall. Stocks fell 9.4% in Japan, 5.9% in the Euro area, and 1.3% in the US. Equity markets are now down 30% or more ytd nearly everywhere—down 40% in Japan, 39% in the Euro area, 33% in the US, and 43% in the EM. 2yr and 10yr UST yields climbed 10bp and 14bp, respectively, to 1.55% and 3.64%. USD slid 0.5% against EUR to $1.365 and dropped 2.3% vs YEN to below 100 for the first time since March.

The Theory of Reflexivity by George Soros, 1994:

"I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy"

 

Because of reflexivity, valuation does not matter. Valuation has been halted for a while, like the Russian stock market. If you need any proof: we have already seen investors PAY the Government to buy T-bills. Or look at corporate cash bonds: some trade at say Libor +800 yields while CDS on these same names is offered at Libor+600... this negative basis trade exists in many many bonds around the world and no one can or will take the other side of the FREE option.