Soros: A Reluctant Appreciation

George Soros is the Rodney Dangerfield of financiers: He don't get no respect.

Sure, he is one of history's most successful market speculators, and one of the world's richest men. But he's not respected in the same way as other high-profile financiers, historical figures like Nathan Rothschild and J.P. Morgan, or modern ones like Warren Buffett and Felix Rohatyn.

That's because these other financiers have used their talent and capital to do well by doing good -- in troubled times they were the strong hands who turned panic into opportunity. But Soros is different: In recent times of chaos in the global markets, Soros' strong hands always seem to hold a smoking gun. He has profited not by quelling panic, but by promoting it.

Soros is best known as the man who broke the Bank of England. His bear-raid on the British pound in 1992 precipitated the collapse of the European monetary system, and resulted in the transfer of billions of pounds from Her Majesty's Treasury to Soros' coffers. He's said to have done it again in the Asian currency crises of 1996 and 1998.

His failures have been just as spectacular, and just as controversial. During the stock market crash of October 19, 1987, since known as Black Monday, Soros became intensely bearish -- he dumped S&P 500 futures on the opening the following day, thus personally contributing to its aftermath, Terrible Tuesday. Of course, the market recovered later in the day, and never again traded much lower. This year, Soros found technology stocks too hot to handle, and dumped them into the spring's Nasdaq crash -- the Composite Index now stands more than 25% above the panic lows.

Those kinds of plays aren't exactly going to secure him the same beloved place in history as Morgan's for his market rescue in the Panic of 1907, or Rohatyn's for his work in saving New York City from insolvency in the 1970s. So, for his sins, Soros contributes billions to philanthropies in Eastern Europe and Russia, and grinds out books expounding his political and financial philosophies.

The positions Soros takes in his books are as bold as those he takes in markets -- and sometimes just as wrong. In 1998's "The Crisis of Global Capitalism," he forecasted the imminent collapse of free-market capitalism on a world scale, triggered as much as anything else by the high-speed, high-leverage machinations of investors such as himself. In an interview last Saturday with The New York Times in connection with yet another book, he confessed, "Basically, I got carried away ... I goofed."

The central concept of Soros' philosophy is what he calls the theory of reflexivity. It is a profound and powerful model for identifying the dynamics of booms and busts, and all serious investors should become familiar with it. When you understand the theory of reflexivity, you can see how Soros employed it to pull off his most spectacular wins. And you can also see how his failure to employ it correctly led to his most spectacular losses.

The theory of reflexivity is explained at length in Soros' books. But you can get a terrific quick-start introduction to it on his Web site, in the text of a speech he delivered at MIT in 1994.

Soros summarizes the theory of reflexivity this way: "...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 reflexivity comes into play, markets go into what Soros calls "dynamic disequilibrium." That means virtuous upside cycles that lead to bubbles and booms, and vicious downside cycles that lead to crises and crashes.

In the European monetary system crisis of 1992, the Bank of England was struggling to defend sterling's price against the German mark as part of its duties under the decades-old Bretton Woods Agreement. Soros took a very public position that the post-Cold War world had changed thanks to the inflationary effects of Germany's reunification, and that the traditional currency relationships would have to change, too.

He forecasted a chaotic break, and then put the theory of reflexivity to work: He risked billions shorting sterling, driving its price lower. He used financial markets to "affect the so-called fundamentals which they are supposed to reflect." Soros, and other speculators who piled on after him, forced sterling down in such a massive assault that the Bank of England could no longer afford to support it. Finally the Bank cried "uncle" and the monetary system was shattered.

When Soros sold the U.S. stock market at the open on Terrible Tuesday in 1987, it may have been because he misunderstood the reflexive nature of the 1987 crash. Fearing that the Black Monday blow to the financial economy would translate reflexively into damage to the real economy, he dumped stocks.

Perhaps what he didn't realize is that Black Monday was itself a reflexive phenomenon -- a cascade effect triggered, exacerbated and perpetuated by wave after wave of futures-selling by investors implementing portfolio insurance. The more the market fell, the more futures they had to sell. The more the futures fell, the more stocks fell in sympathy, and so on and so on. The cycle burned itself out when the portfolio insurers ran out of bullets -- unfortunately, that's right where Soros sold.

The bust in Internet stocks this year can be interpreted through the theory of reflexivity. Young companies without earnings are critically dependent on the ability to raise money in financial markets. When their stock prices are rising, financing is assured and an important risk is eliminated -- the rising price itself makes the company more viable, which in turn leads to an even higher price, which makes the company more viable still. The same thing happens in reverse when stock prices decline. The risk of future financing increases, so the stock price falls further, which increases the risk even more, which causes further decline, and so on and so on, reflexively.

Did Soros understand the reflexivity in Internet stocks when he loaded up on technology at the top, and dumped at the bottom? He hasn't said, one way or the other.