Personal Finance: Last of the money markets

One of the world's top investors, George Soros, is predicting the end of capitalism as we know it
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Indy Lifestyle Online
As if there weren't enough things to worry about already, there is always the collapse of capitalism to sweat about. This week, for at least a few hours on Wednesday, the markets had another of their turns, sparked in this case by an 8 per cent devaluation of the Brazilian real, and consequent fears that the next great collapse in the global chain reaction that began in the Far East some 18 months ago might now be about to start in Latin America.

Early on Wednesday, Wall Street was down sharply at one point and London followed suit - by lunchtime this latest market crisis, like many before it, seemed to have abated.

Brazil's economy has been vulnerable for some time, given its huge budget deficit and debt burden, and the large run of capital outflows from the country. If nothing else, the episode does at least demonstrate how genuinely jittery the financial markets have become - and with good reason, since valuations of many leading shares in both New York and London have clearly parted company with reality. The Americans have a powerful vested interest in keeping Brazil afloat, which was less true of the Far East, and they may well manage to help Brazil pull through any threat of financial meltdown.

But are we really facing something worse than market jitters? This week, I have been taking a more detailed look at the argument advanced by George Soros that the global capitalist system is not only "unsound and unsustainable", but is "in fact, disintegrating". Having ploughed my way through both his earlier books, I can say with authority that this is not a step to be taken lightly. Soros in print is no easy read, and many of his ideas often appear ludicrously exaggerated until you get used to knowing what to take with a pinch of salt and what not.

However, his latest offering is full of quite fascinating insights, not least into how financial markets and top-shot investors such as Soros himself operate. In the autumn, I mentioned how useful his public statements were as a short term indicator of what not to expect to happen. One of the superficial mysteries about Soros is how he has managed to make so much money over so many years - his long term record as a hedge fund investor is still unparalleled - while seemingly being so wrong whenever he opens his mouth and makes a public prediction about the future course of events.

This mystery is partially explained by the fact that, according to his own testimony, his whole philosophy of investment is built around the recognition of how little most market participants (including himself) actually know about what is happening, or going to happen, in the markets.

"As a fund manager," he says now, "I depended a good deal on my emotions. The predominant feelings I operated with were doubt, uncertainty and fear. I had moments of hope or even euphoria, but they made me feel insecure. Worrying made me feel safe." Knowing how ignorant he was gave him an edge, he thinks, over investors who find it hard to admit that they might be capable of mistakes.

Operating in the financial markets, he adds, requires "a different mind- set" from that "required for operating in a social, political or organisational setting, or indeed for acting like a normal human being".

Elsewhere he explains how he made most of his money by backing what he calls "fertile fallacies". His thesis is that as prices in all financial markets are based on estimating the current value of future earnings or dividends streams, which by definition are unknowable with any certainty, they inevitably operate in a permanent state of potential disequilibrium.

They are also subject to the principle of reflexivity, his pet term for the idea that what people think today - their expectations of the future - are themselves a powerful factor in determining what does happen. These feedback loops help to generate the repeating pattern of boom/bust cycles which is the essential characteristic of nearly all markets.

The Soros investment philosophy has been based, he says, on taking bets on where we are in those cycles: going long of a concept, however misguided, in its early stages and then selling it short in time to make more profit from its meeting with reality.

The important point to grasp is that the commodity he trades in is not, in fact, economic reality, which is unpredictable and fluid, but the fluctuations in other investors' expectations, which he, at least, has always found much easier to track and profit from. His motto, he says, was always, "Invest first. Investigate later", relying on his ability to work out what was wrong with the current prevailing hot thesis, before the rest of the market caught on.

One aspect of this view of how markets work is the important point that "trend-following behaviour is not necessarily irrational. Just as certain animals have good reasons to move in herds, so do investors. Only at inflection points will mindless trend-followers get hurt, and if alert enough they are likely to survive. By the same token, lone investors who hitch their fortunes to the fundamentals are liable to get trampled by the herd."

(Which is exactly what has happened to those high-minded UK fund managers who have shunned Wall Street consistently for years because it is so overvalued - missing the point that trends can run for long periods before they expire.)

One further complication, Soros says, is that more professional investors are aware of his way of thinking today than they were before. As a result "trend-following behaviour" is on the rise, and "belief in fundamentals is eroding".

This is a further source of instability in the financial system. So, too, is the performance measurement system which now judges every conventional fund manager's actions on how well he does in relative terms, not on how much money he has made.

To my mind, Soros makes a convincing case for believing that all financial markets are inherently unstable. Whether he is right that the capitalist system itself is in jeopardy is less clear-cut. His purpose in going public with his concerns now is, at least in part, polemical.

He thinks we lack the international institutions to moderate the unfettered system of international capital flows that prevail. He is worried about the consequences of their being not up to the job. He may be right, I don't know. But his analysis tells us a lot about how we have reached the state of "irrational", precarious "exuberance" that the markets are in.

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