Monday, August 17, 2009

The New Paradigm for Financial Markets


"Living in London was a comedown. I had no money and no friends. After my adventurous life, I was full of myself, but the people in London was not interested. I was an outsider looking in, and I discovered lonliness. There was a moment when I ran out of money. I was having a snack at a Lyons Corner House, and after paying for my food I had no money left. "I have touched bottom," I told myself, "and I am bound to rise, This will be a valuable experience."
-George Soros

I was reading this book for the second time ever since I bought it. But what really caught my eye this time wasn't the Theory of Reflexitivity or the predictions that Mr. Soros made that turned out to be right or wrong. Rather, what caught my attention was the fact that I could sense his determination in the face of extreme adversity. The intense emotions that were described by a mere few words that made the read all worth while.

Though readers with mindset of a higher order should dwell into the abstractions of Reflexitivity, the idea is pretty simple but difficult to prove. However, this economic rally can potentially verify his ideas. The equity market rebound began in March way before other economic inidicators turned positive. Later several indicators did in fact turned positive whilst others continued to languish. An empirical observer would say that economic signals are more mixed rather than unidirectional. The euphoria driven by "animal spirits" could be said to be, a product of successful propaganda and media control. Perception is not reality, but perception drives reality.

If this rally were to be sustainable and rise in the various asset classes were to successfully generate a cumulative wealth effect. Then it would give us a better insights into how financial markets operate. Fundamentals drive sentiment or is it sentiment that drives fundamentals?

Students of financial literature, myself included, are educated and trained to place much more weight on underlying fundamentals. However, before the crisis came upon us, I could still remember several analysts declaring that the sub-prime crisis would be contained and have minimal impact if any at all. They pointed out to figures of earnings which justifiably show that the fundamentals of several companies continue to hold strong. Record earnings, record sales and strong financial positions, the fundamentals could never been better. What a difference a year has made!

Now fundamentals are down substantially and the future from my point of view remains rather bleak. There could be 2 explanations to such a phenomenon:

1) Our perception of what constitutes to be "strong fundamentals" are flawed and investors forgot to ask themselves "How much?";
2) Fundamentals are really driven by sentiments or "animal spirits" which should really be an essential part of economic theory.

Though I was inclined to believe the former, but with each passing day I find myself swayed towards the latter. However, all is not set in stone yet for the definitive answer could only be determined by the future.

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