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The Alchemy of Finance by George Soros

January 14th, 2009

Page 52 – The Market’s ‘Predictive’ Power

The stock market is generally believed to anticipate recessions.  Soros believes the market not only anticipates recessions, but it can also help precipitate and aggravate recessions.  He believes that once the markets start to turn down, it then become a primary instigator of the impending recession. He replaces the assertion that the markets are always right with:

  1. Markets are always biased in one direction or another.
  2. Markets can influence the events that they anticipate

The combination of these two assertions explains why markets so often appear to anticpate events correctly.  Once again, Soros’s theories assert that the ‘prevailing bias’ self reinforces the fundamentals.

Page 59 – The Boom / Bust Model

There is bound to be a flaw in the participants’ perception of the fundamentals, which is likely to manifest itself at a later time.  When it does, it sets the stage for a reversal of the prevailing bias. If the change in bias reverses the underlying trend, a self reinforcing process will be set in motion in the opposite direction. Knowing ahead of time what the flaw is, and how it is likely to manifest itself, are the keys to profiting from the boom / bust sequence.

The crucial features of Soros’s boom / bust model are as follows: unrecognized trend -> beginning of a self-reinforcing process -> successful test  of the trend -> growing conviction in the trend, resulting in a widening divergence between reality and expectations; recognizing the flaw in perceptions; the climax; a self-reinforcing process in the opposite direction.

By identifying these features of a reflexive boom / bust sequence, it is possible to gain some insight into the direction of stock prices.

The ingrained view is that stock prices incorporate all expectations and all information and that they are a passive reflection of reality at a point in time.  However, Soros believes prices are an active incredient in the direction of fundamentals and that prices will affect reality.

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