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COLUMN
How To
Speculate: A Billionaire's Perspective
By EDWARD E. AYOUB
Release Date: November 30, 1999
© 1999 Macroknow Inc. All Rights Reserved.
So you want to get rich. Then speculation in financial
markets may be the right strategy for you. But, before dabbling in
speculation, you'd better master what it takes to come out ahead. This
column is designed to help you get started.
First, you must study the works of the master speculators -- like George
Soros, billionaire financier and philanthropist. Soros is the author of
The Crisis of Global Capitalism [Open Society Endangered] (PublicAffairs™,
New York, 1998)1. His book is full of
in-your-face insights. Here are two examples: "Everybody must look out for
his or her own interests and moral scruples can become an encumbrance in a
dog-eat-dog world" and "people who are not weighed down by any consideration
for others can move around more easily and are likely to come out ahead."
The principle of
amorality
If you want to get rich, the first thing you must understand is that
"financial markets are not immoral; they are amoral." Soros cants this
principle again and again -- but he warns that amorality has its price.
The principle of amorality appears to be grounded in the principle of
"fallibility." Fallibilism was promoted by the philosopher Karl Popper in
The Open Society and Its Enemies. Like Popper, Soros believes that no
one is capable of knowing the absolute truth. And, if truth is beyond human
reach, then no one can tell what is ultimately right and what is ultimately
wrong.
"Everybody must look out for his or her own interests and moral scruples
can become an encumbrance in a dog-eat-dog world"
-- George Soros
For speculators, fallibilism has its reward. The
reward is called "reflexivity." Learn how to seek it, and you can, like
Soros, generate huge profits. The truth may be beyond your reach, but not
riches.
What is
"Reflexivity"
What is "reflexivity" you ask? According to Soros, it is the two-way
interaction between thinking and reality. Reality and thought are not the
same thing; they interact and they influence each
other. Perfect truth occurs when reality and thought coincide perfectly.
But, how often does this happen? Speculators exploit the gap between reality
and thought, especially when it is extreme, to make huge profits. How? They
exploit the present when the present reflects other people's fallible
expectations about the future. Let me explain.
The secret
meaning of "time" and how to exploit it
The secret meaning of time was first revealed by St. Augustine in
Confessions. What is this secret? Neither the past nor the future
exists. Only the "immediate vision" of things present exists. Augustine
taught that the past is the present memory of things past, and the future is
the present expectation of future things. A blunt consequence of this theory
of time is this: To manipulate the present, you must manipulate the
expectation of future events.
Augustine's insight unconceals how reflexivity in financial markets
allows clever speculators to get rich. The price of a share of common stock
is its present value. This is the sum of two kinds of discounted cash flows:
The quarterly dividends the investor expects to receive until the stock is
sold, and the price he or she expects to pocket when the stock is sold. Both
cash flows are expected future values, and both depend on future earnings
per share. In other words, the price of a stock is conditioned by present
information about future expected prices and earnings, and these
interact continuously. Therefore, to exploit a stock's price, you must
exploit the fallible present expectation of its future "fundamentals." But
how? Well, this is where the boom/bust process comes in.
According to Soros, the "ideal" boom/bust process has eight stages. The
boom process is initiated when financial values become "reflexive." That is
when expected earnings inflate stock prices and inflated stock prices
inflate the expected earnings, in a mutually "self-reinforcing" way. This
vicious cycle creates an increasing gap between price expectations and
reality. When the gap becomes incredible, a "self-correction" process sets
in. The self-correction can accelerate and get out of control. When this
happens, the bust culminates with a catastrophic price meltdown or crash.
But don't worry. Other people's problems can be your opportunity. You cannot
be held responsible for other people's fallibility!
How good is Soros' model? It is very good. But don't take my word for it.
Take a look at how the price and EPS data for fallen stars around the globe
have unfolded and judge for yourself.
How to benefit from
the boom/bust model
Can you benefit from Soros' model? Sure, with a caveat: Models are
fallible. And what strategies can be gleaned from the model? Here are just a
few. Use them at your own risk. For Soros’ comprehensive model and analysis,
you must consult Soros' works.
Seek stocks whose price expectations and
fundamentals are "reflexive." This is an acquired reflex (no pun
intended). You must be able to pick up "the scent" of a self-accelerating
process that is waiting to crash. In this connection, it is amusing to
note Soros' description of his own physiological response to reflexivity:
"I used to get particularly excited when I picked up the scent of an
initially self-reinforcing but eventually self-defeating process. My mouth
began to water as if I was one of Pavlov's dogs."
Always look for your own interest. Be amoral. This
way, you can never be too encumbered. There is an important corollary to
this: You must "play by the rules."
Focus exclusively on maximizing your profits. Here,
your thinking must become calculative and focused on weighing risks versus
rewards. You can profit on the upside if you buy stocks in the early
stages of the boom process, then sell them before they peak. You can also
profit handsomely on the downside if you buy the most valuable parts of
the crashed company late in the bust stage, at rock bottom prices, then
wait until prices recover. In the latter case, it helps if you are a rich
financier or own a big bank -- or if your business is vulture
capital.
One final note. The current spectacular boom in U.S. stocks will be
followed by a nasty bust, perhaps a global crisis. So, maximize your profits
while you can, but prepare for the darkness that lurks around the corner.
Reference
1 George Soros, The
Crisis of Global Capitalism: Open Society Endangered. New York, NY:
Public Affairs, 1998.
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