You may never have studied economics or investment finance, but I bet you understand the fundamentals. The academic theories really aren’t rocket science.
In fact, they’re usually nothing more than stating the bleeding obvious and wrapping it up in a pseudo-mathematical model.
Take the efficient markets hypothesis (EMH). All it really says is that the markets are always right – or at least that you can’t beat the market by looking at past prices. So, if house prices average six times salary, then that’s what it is. And you’re not to question the validity of that price!
I won’t bore you with the mathematical modelling, not least because it’s a load of rubbish. Its very foundations are falling apart as we speak.
But there is an alternative to EMH that is very useful. It’s one that academics hate – it’s too difficult to model, so they ignore it.
But this is a theory that has stood me in good stead – a market theory developed by the mighty George Soros. And it’s one that has helped to make me serious cash when markets become irrational.
Today, I want to show you how this theory works using house prices.
George Soros and the reflexive market
The academics say there’s a fundamental value for any asset, and the market never strays far from that valuation. But of course that’s a lunatic proposal – the likes of George Soros would never have become a self-made billionaire by listening to clap-trap like that.
Soros studied at the London School of Economics during the early fifties. And it was then that he came up with his own theory about how markets work.
Soros realised that the fundamentals used to make a valuation change as investor perception changes.
During the mid 90s, UK house prices started to go up. They started off cheap as we came out of the 90s recession.
As prices went up, perceptions started to change. This is how it happened:
Bank balance sheets got stronger and stronger. Bad loans on housing were almost non-existent during the late nineties and early noughties. That allowed the banks to loosen lending standards. Over the years, they moved from lending out three years’ salary, right up to crazy multiples like seven, or eight times.
All the while, borrowers lucky enough to be in on the game bought more and bigger houses. Prices were chased up and all the while the banks’ balance sheets got stronger and stronger.
Strong bank and personal balance sheets allowed punters to borrow monstrous amounts of money. In fact, self-certified mortgages didn’t require much more than some made up numbers to get some fat loans.
And because banks made so much ‘risk-free’ profit on mortgages, they trimmed back their margins. Effectively mortgage rates were slashed to the core – special discount deals and fixed rates put a skyrocket under prices.
You see how the fundamentals for valuing houses changed because of the bull market itself?
Of course you can’t ignore the fat hand of government in all of this. Government policies tend to favour home ownership. In the States, the government practically is the mortgage market; and most governments allow tax-free speculation on personal property. Government policy amplified the changing fundamentals.
A market that feeds back on itself like this is called a reflexive market. Let’s see how we can profit from it today.
Not all markets are reflexive
I’m happy to concede that most of the markets are mostly efficient, most of the time. That’s the bleeding obvious bit that even the academics get.
But if you want to make serious investment gains, then you need to look out for the odd occasions when markets get irrational. That’s when you win big, or lose big.
Soros noted that for markets to get reflexive, you need two things: leverage and trend following.
There’s certainly leverage involved in the housing market. And yes, as the Smiths, keep up with the Joneses and the national dinner topic turns to house prices, you can see that there’s trend following too.
It can happen in stock markets. During the roaring twenties in the run-up to the great crash, punters took on massive leverage to buy US stocks. And the dotcom boom wasn’t much different; the trend-followers were certainly aboard.
So what’s going to be the next market to go reflexive?
I would say precious metals. I think gold and silver could start to head down the road of irrational exuberance pretty soon.
It’s why I say the market is not in a bubble… Yet!
There simply isn’t enough leverage on gold investment for a bubble. And despite a few headlines in the financial press, I don’t see much evidence of trend following.
Now of course these markets may never get to the reflexive stage where the fundamentals (in this case currency breakdown) are brought about by gold’s very own bull market.
All I’m saying is we’ve not got there yet. Buy gold and wait for the leveraged trend followers to hop aboard. Then you’ll see how far gold can really go.
If you’re worried that you’re too late, then why not buy gold stocks?
Gold stocks have severely lagged the gold bullion market. I guess many stock market investors think the gold price rise will be short-lived.
But if that perception changes, the stocks have got some serious catching-up to do. Looking at the recent chart of the gold miners, then the catch-up phase has started.
Read MoneyWeek’s gold guru Dominic Frisby’s report on the gold miners here – a fascinating read with five great gold mining tips.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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