Markets Often Change When Beliefs Change

 | Feb 12, 2018 | 1:00 PM EST
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A Successful Test on Friday May Lead to a "Tradeable" Rally -- But Trouble Lies Ahead Over the Balance of the Year

"History doesn't repeat itself, but it does rhyme" -- Mark Twain

The quote above has been indelibly etched in my mind and I have thought about Mark Twain's observation often during my career of over four decades in the investment business.

So, too, have I been influenced by George Soros -- arguably the greatest speculator in modern investment history.

Both have taught me that markets don't necessarily change when fundamentals change; markets often change when beliefs change.

Back to the Future and Soros' "Theory of Reflexivity"

When Warren Buffett was once asked about the key to success, he pointed to a stack of nearby books and said, "Read five hundred pages like this every day. That's how knowledge works. It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it."

Of all the investment books I have read in my life (and I have read many), George Soros' The Alchemy of Finance: Reading the Mind of the Market stands out.

In his seminal book, George Soros describes his theory of reflexivity. It was what he attempted to write his PhD on, but the theory was tested in the way he applied it to the financial markets. The central thrust of the theory is that market participants are biased. As opposed to making consistently rational investment decisions, market participants jump on trends in a self-reinforcing and self-fulfilling manner. As opposed to trending towards equilibrium, the financial markets perform in line with the biased expectations of the participants.

Such has been the case of the markets over the last few years and, particularly, during the month of January when volatility was squashed and a fear of missing out ("FOMO) was the prevailing sentiment/emotion -- in a market overshoot that took the S&P Index to close to 2900.

Soros goes on to argue that the more people who believe in the efficient markets hypothesis, the less stable financial markets will actually be. Some of his comments with respect to what I call "groupstink" are very prescient when we think about what happened in the sub-prime mortgage boom and in today's shifting and dangerous market structure (and the adverse impact it has recently had on share prices and increased volatility).

Soros disagrees with the idea that markets trend towards equilibrium. He rails against the theory of perfect competition, arguing that imperfect knowledge is almost always the case. In fact, he argues that based on his observations in the financial markets that they tend towards excess as opposed to any form of reality-based valuation.

He uses the rise of conglomerates in the 1970's to illustrate that executives started creating conglomerates simply because other companies were and because the price/earnings multiples for conglomerates were rising faster than other categories of stock. By jumping on the trend they could raise their share price and earn higher performance bonuses. (1970's executive earnings were several standard deviations below the obscenities of today). Eventually the conglomerates over-extended and suffered major losses. Up until that point no one took a step back and thought about things. They merely jumped on the trend.

Finally, in his book, Soros argues that regulators are always one step behind the private sector. (And this is certainly the case of the SEC -- who fell asleep during the mortgage crisis in the mid-2000s as financial weapons of mass destruction were marketed around the world and today, with regard to volatility-linked products, that seem to be a distant cousin of those levered mortgage products).

The Current State of the Markets - Short Term Bullish/Intermediate Term Bearish

After the market closed on Thursday I wrote that I was turning more positive on the markets and I began to accumulate a trading long rental in Spyders at about $258 based on my belief that we were following history as a guide. (Here was my logic as expressed in that column in my Diary.

Specifically, the last structural market liquidity event, the Portfolio Insurance -- inspired decline in October, 1987 exhibited a pattern that could be repeated in 2018's liquidity event which was importantly influenced by the breakdown in volatility linked products (which had accumulated to over $1.5 trillion in invested assets) -- a concern I held on to for the last several months.

That October, 1987 pattern of a Monday waterfall decline, followed by a "Turnaround Tuesday" and then a quick retest later in the week of the early morning Tuesday low -- may, I suggested, be repeated again in February, 2018. The early Tuesday morning (premarket) low of 2545 on the S&P futures (and $254.50 on Spyders) also coincided with an important moving average for the S&P Index:


Source: The Divine Ms M.


In Friday's tumultuous trading session, the S&P Index had more moves than a shortstop batting .110. First up, then down dramatically, then a rally, then another drop, followed by a remarkable rally in the last hour -- the markets indeed tested (and fell slightly) below the critical Tuesday futures low and stopped at the moving average (see the chart above).

It is my view that, at 2535 (at about 1:40 pm on Friday) we hit a capitulation trading low.

Following the first retest in late October, 1987 -- the markets rose by about +11%. A similar move would take the S&P back to about 2800 -- but I believe that is too optimistic. Given current headwinds, a gain of closer to +7% to +8% from Friday's bottom seems more probable (2725 S&P).

So, if the historical relationship holds, we will rally some more over the near term and then have another retest in about 5-6 weeks from last Monday's waterfall decline.

The balance of the year will likely be challenging as described ahead in this post.

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To read Part II of Markets Often Change When Beliefs Change, click here.

To read Part III of Markets Often Change When Beliefs Change, click here.

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