Reflexivity, Bubbles and Profits

by Doug Noland

August 23, 2014



Market "risk on" - in the face of a risky and unstable world. 

My analytical framework owes a debt of gratitude to, among others, George Soros. His 1987 classic The Alchemy of Finance,” particularly his Theory of Reflexivity, has profoundly influenced the way I view the markets, economics and the world.

From Wikipedia: “Economic philosopher George Soros, influenced by ideas put forward by his tutor, Karl Popper (1957), has been an active promoter of the relevance of reflexivity to economics, first propounding it publicly in his 1987 book The Alchemy of Finance. He regards his insights into market behaviour from applying the principle as a major factor in the success of his financial career

Reflexivity is inconsistent with equilibrium theory, which stipulates that markets move towards equilibrium and that non-equilibrium fluctuations are merely random noise that will soon be corrected. In equilibrium theory, prices in the long run at equilibrium reflect the underlying fundamentals, which are unaffected by prices. Reflexivity asserts that prices do in fact influence the fundamentals and that these newly influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles. An example Soros cites is the procyclical nature of lending, that is, the willingness of banks to ease lending standards for real estate loans when prices are rising, then raising standards when real estate prices are falling, reinforcing the boom and bust cycle.”

In simplest terms, I explain reflexivity as “perceptions creating their own reality.” I would argue that the concept of “reflexivity” has never been as important as it is these days. The self-reinforcing nature of Credit cycles has played prominently throughout history. I have argued for years that the move to market-based Credit instruments (i.e. securitizations vs. bank loans) has profoundly exacerbated the inherent instability of Credit, market and economic cycles. Moreover, the instability and fragility of contemporary market-based Credit has over time engendered progressively more activistgovernmental market manipulation and intervention.

The headline certainly caught my attention: “George Soros bets $2B-plus on stock market collapse.” At less than 17% of fund assets, I don’t want to get too carried away with Soros’ bearish bet/hedge. At the same time, it does support my view that the sophisticated market operators have begun to pare some risk. Further confirmation came in Thursday’s Wall Street Journal articleNervous Hedge Funds Turn Defensive on Concerns Over Asset Prices.”

Also, interestingly, from Thursday’s Wall Street Journal (Kirsten Grind): Investors Pour Into Vanguard, Eschewing Stock Pickers. Investors are pouring money into Vanguard Group, the epitome of the hands-off approach to investing, flocking to funds that track market indexes and aren't run by stock pickers or star managers. The inflow has pushed the mutual-fund giant to almost $3 trillion in assets under management for the first time. The surge is part of a sea change in the fund business in which investors are increasingly opting for products that track the market rather than relying on managers to pick winnersInvestors poured a net $336 billion into passively managed stock and bond funds in 2013, handily beating the $53 billion invested in traditional mutual funds of the same type, according to Morningstar. So far this year through July, investors put a net $177 billion into those passive funds, compared with $74 billion in actively managed funds… Through July, passively managed stock funds have seen a net $128.4 billion in investor inflows, compared with $18 billion for traditional stock funds…”

The contrast between hedge fund risk aversion and “money flooding into index products stimulates the analytical brain. Certainly, the notion of “distribution” from the sophisticated market operators to the less sophisticated comes to mind. Yet so-calleddumb moneydoesn’t do justice when it comes to explaining the incredible $500bn that flooded into (largely ETF) index products over the past 18 or so months. Wow.

Credit Bubbles and financial manias are most fascinating. The written history of some of the more notorious Bubbles too successfully paints monetary fiascos as events driven largely by manic obsession with tulip bulbs or various financial instruments. As a student of the monetary inflations/distortions that underpin market Bubbles (“manias”), I take a differing view.

As much as Bubble episodes seem absolutely ridiculous in hindsight (Internet stocks 1999, subprime 2006), they do not appear as such in real time. Indeed, the perceived rationality of participating in the boom is integral to Bubble Dynamics. By 1999, it had become obvious that technological innovation was changing the world – and that tech stocks only went up. By 2006, who could argue against the view that home prices only rose and loan losses were a non-issue? Was borrowing at historically low rates to buy a home irrational? How about speculating in higher-yielding MBS? After all, and as was clearly understood throughout the economy and markets (thanks to various bailouts and market interventions), Washington and the Fed would never allow a housing bust. These days, it’s not irrational for “money” to flood into funds indexed to equities and corporate Credit. At this point, there is absolutely no doubt that Washington, the Fed and global central banks would never allow a securities market bust.

To better appreciate today’s Bubble, it is first necessary to understand previous Bubbles and the evolution of policymaking and market perceptions. Frankly, I am astonished by the almost complete lack of understanding of key mortgage finance Bubble dynamics

And the more time that passes the greater historical revisionism’s sway. The Fed insists that monetary policy and interest-rates were not responsible. It was instead a case of overzealous lending and regulatory failureall correctable; won’t happen again.

I would strongly argue that the so-calledworst financial crisis since the Great Depression” was at its root caused by momentous financial distortions that incentivized a historic expansion of mispriced mortgage Credit. The Fed’s extremely low pegged interest rates incentivized aggressive lending and leveraged speculation. Importantly, the Fed and Washington validated the market’s perception that Fannie and Freddie securities were free of default risk. The perception of unlimited cheap liquidity coupled with a Federal Reserve market liquidity backstop completely distorted the pricing of mortgage Credit throughout the system. The Fed-induced backdrop simply made it too easy to garner profits in lending, securities speculation and home buying. In terms of “reflexivity,” the perception of unending mortgage Credit growth, housing price gains, economic growth and robust financial markets ensured a (fatefully) protracted boom.

The Fed, the GSE’s and the government more generally made mortgage lending and housing appear virtually risk-free; mortgage securities becamemoney”-like. I have argued that during the ongoing global government finance Bubble this dynamic evolved to encompass virtually all asset markets. The fundamental issue of “Moneyness of Creditdistortions throughout mortgage finance evolved to “Moneyness of Risk Assetsvirtually across all asset classes on a globalized basis. This is the essence of why I focus on the “Granddaddy of All Bubbles,” while most see a healthy bull market.

Mounting systemic fragility went virtually unnoticed during the mortgage finance Bubble period. Late-stage financial and economic vulnerabilities were masked by what was perceived as extraordinary opportunities to profit from the boom. It went unrecognized that profits throughout both the real economy and financial system would transform into massive losses come the inevitable bursting of the Credit Bubble.

The conventional view holds that a market Bubble is defined by asset prices diverging from underlying fundamentals. To most, Bubbles are simply about overvaluation. My analytical framework holds that Bubbles are fueled by some underlying monetary disorder that actually works surreptitiously to inflatefundamentals.” The stock markets didn’t appear significantly overvalued in 2007 – or 1929 for that matter. In 1929, 1999 and 2007 virtually everyone was extrapolating ongoing prosperity. These days, it is taken for granted that corporate profits will grow steadily for years to come. I believe strongly that inflating profits” are the centerpiece of today’s Bubble, similar to how inflating home prices were the cornerstone of the mortgage finance Bubble.

First of all, I always believed that Washington monkeyed with home prices at its own peril. As beguiling as rising home prices and affordable mortgages were for politician and voter alike, policies that stoked home price inflation and “affordable housing” were playing with (Bubble) fire. As history proved, housing market stability is integral to a sound financial system and economy. I believe stability in the backdrop for corporate profits is similarly essential for financial and economic stability. Should it be within the Fed’s mandate to monkey with profits hence securities prices and wealth distribution?

The Fed specifically targeted mortgage Credit for its post-“tech Bubble reflationary policies. An even more incredible effort to inflate equities (and risk markets) has been the centerpiece of the Fed’s post-mortgage finance Bubble efforts. While not generally appreciated, various Washington policy measures have worked in concert to inflate corporate earnings. Massive deficit spending was instrumental in funneling purchasing power throughout the real economy, in the process significantly boosting corporate cash-flows and profits. 

Meanwhile, Fed policies have inflated corporate profits in various ways, some more obvious than others. Clearly, the collapses in the Fed funds rate and market yields dramatically reduced debt service costs hence boosted profits throughout corporate America. For the household sector, the Fed-induced fall in mortgage borrowing costs reduced debt service for homeowners, in the process providing additional spending power (and corporate profits!).

There are myriad other facets of monetary policy that have had a major, if not appreciated, inflationary impact on profits. I believe QE has had a profound impact on corporate cash flows, earnings and balance sheets. Fed liquidity injections have created purchasing power throughout the economy, while also stocking asset prices and attendantwealth effects.” Moreover, by dramatically manipulating market yields lower while inflating market liquidity, the Fed has provided extraordinary incentives for financial engineering and M&A. Unprecedented stock buybacks, in particular, have been instrumental in boosting stock prices and earnings-per-share.

Perhaps most importantly for this cycle, the Fed’s move to unlimited quantitative easing emboldened the market perception of infinite central bank liquidity support. This perception has manifested most directly into a powerful collapse in risk premiums, with profound self-reinforcing effects on Credit availability, debt service costs, profits and securities valuation for U.S. and global corporations.

Total Non-Financial Debt growth surpassed $1.0 TN for the first time during booming 1999 (nineties annual avg. $721bn). Non-Financial Debt growth surpassed $2.0 TN annually for the period 2004-2007. The doubling in mortgage Credit had a profound inflationary effect on home prices, along with spending and corporate profits. I have argued over recent years that the mal-adjusted U.S. Bubble economy requires about $2.0 TN of annual Credit growth for the appearance of a sustainable boom. Importantly, this amount of system Credit expansion is necessary to sustain inflated corporate profits.

The big issue I have – and why I am convinced in the Bubble thesis – is that I don’t believe $2.0 TN of Credit growth is sustainable. Supposedly, the Fed will soon be concluding its historic balance sheet expansion (monetary inflation). To this point, the perception holds that the recovery is on track and global central banks will continue to backstop the markets and global economy. And as long as “moneycontinues to flow to risk markets and the speculators keep the faith, then booming markets (underpinned by massive buybacks and M&A) support spending, economic activity and corporate profits. I’m the first to admit that the now protracted global government finance Bubble has attained significant momentum.

There is ample support for my view that financial speculation and securities market leveraging are today unprecedented on a global basis. On the one hand, this financial Credit has been instrumental in both inflating securities prices and fueling the Bubble in profits. The inflation of the Fed’s (and other central banks’) liabilities (“money”) has been fundamental in incentivizing securities speculation. Just as the Fed was never to tolerate a housing bust, it is now taken on faith that central banks would never allow a securities market liquidity crisis. The 2008/09 market dislocation and crisis were manifested by market recognition that the Fed could not sustain the mortgage finance boom.

I expect the next crisis to likely revolve around the harsh reality that central banks cannot guarantee robust and liquid markets. Actually, reflexivity ensures that perceptions of limitless cheap liquidity and market backstops ensure the type of excess that inevitably ends in liquidity crisis. When this historic Bubble bursts, corporate profits will be one of the more prominent casualties. And in the fascinating world of Bubble analysis, I can confidently posit that the Fed is oblivious to the unfolding financial stability problem. They clearly don’t appreciate the Bubble they have induced in corporate profits and the ramifications for the true overvaluation of corporate securities generally – both equities and bonds.

Soros has taken a bearish position through the purchase of put options on the S&P 500. Surely he is not alone in looking at relatively inexpensive market insurance for downside protection (as myriad risks become increasingly apparent). These types of instruments tend to exacerbate market volatility. In market declines, those that have sold/written market insurance must dynamically hedge this exposure, which can lead to self-reinforcing selling. At the same time, these types of bearish bets also provide buying power when markets reverse course and rally. This helps to explain why markets (think 1999 or 2007) tend to go into speculative melt-up mode right into the face of deteriorating fundamentals.

It’s also worth noting that the hedge fund industry is generally struggling with performance again this year. Ironically, all the “moneyslushing into index products only makes the job of generatingalpha” from stock picking all the more challenging. There are many reasons I suspect the markets have entered a period of heightened volatility.


The Greater Depression

J. Bradford DeLong

AUG 28, 2014




BERKELYFirst it was the 2007 financial crisis. Then it became the 2008 financial crisis. Next it was the downturn of 2008-2009

Finally, in mid-2009, it was dubbed the “Great Recession.” And, with the business cycle’s shift onto an upward trajectory in late 2009, the world breathed a collective a sigh of relief. We would not, it was believed, have to move on to the next label, which would inevitably contain the dreaded D-word.

But the sense of relief was premature. Contrary to the claims of politicians and their senior aides that the “summer of recovery” had arrived, the United States did not experience a V-shaped pattern of economic revival, as it did after the recessions of the late 1970s and early 1980s. And the US economy remained far below its previous growth trend.

Indeed, from 2005 to 2007, America’s real (inflation-adjusted) GDP grew at just over 3% annually. During the 2009 trough, the figure was 11% lower – and it has since dropped by an additional 5%.

The situation is even worse in Europe. Instead of a weak recovery, the eurozone experienced a second-wave contraction beginning in 2010. At the trough, the eurozone’s real GDP amounted to 8% less than the 1995-2007 trend; today, it is 15% lower.

Cumulative output losses relative to the 1995-2007 trends now stand at 78% of annual GDP for the US, and at 60% for the eurozone. That is an extraordinarily large amount of foregone prosperity – and a far worse outcome than was expected. In 2007, nobody foresaw the decline in growth rates and potential output that statistical and policymaking agencies are now baking into their estimates.

By 2011, it was clearat least to me that the Great Recession was no longer an accurate moniker. It was time to begin calling this episode “the Lesser Depression.”

But the story does not end there. Today, the North Atlantic economy faces two additional downward shocks.

The first, as Lorcan Roche Kelly of Agenda Research noted, was discussed by European Central Bank President Mario Draghi while extemporizing during a recent speech. Draghi began by acknowledging that, in Europe, inflation has declined from around 2.5% in mid-2012 to 0.4% today. He then argued that we can no longer assume that the drivers of this trendsuch as a drop in food and energy prices, high unemployment, and the crisis in Ukraine – are temporary in nature.

In fact, inflation has been declining for so long that it is now threatening price stability – and inflation expectations continue to fall. The five-year swap rate – an indicator of medium-term inflation expectations – has fallen by 15 basis points since mid-2012, to less than 2%. Moreover, as Draghi noted, real short- and medium-term rates have increased; long-term rates have not, owing to a decline in long-term nominal rates that extends far beyond the eurozone.

Draghi’s subsequent declaration that the ECB Governing Council will useall the available unconventional instruments” to safeguard price stability and anchor inflation expectations over the medium-to-long term is telling. The pretense that the eurozone is on a path toward recovery has collapsed; the only realistic way to read the financial markets is to anticipate a triple-dip recession.

Meanwhile, in the US, the Federal Reserve under Janet Yellen is no longer wondering whether it is appropriate to stop purchasing long-term assets and raise interest rates until there is a significant upturn in employment. Instead, despite the absence of a significant increase in employment or a substantial increase in inflation, the Fed already is cutting its asset purchases and considering when, not whether, to raise interest rates.

A year and a half ago, those who expected a return by 2017 to the path of potential outputwhatever that would beestimated that the Great Recession would ultimately cost the North Atlantic economy about 80% of one year’s GDP, or $13 trillion, in lost production. If such a five-year recovery began now – a highly optimistic scenario – it would mean losses of about $20 trillion. If, as seems more likely, the economy performs over the next five years as it has for the last two, then takes another five years to recover, a massive $35 trillion worth of wealth would be lost.

When do we admit that it is time to call what is happening by its true name?


J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.