What George Soros can teach you about gold and house prices

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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  • camilla

    so why did george sorous sell his gold?….a friend says he only sold his ‘paper’ gold..is this the case?..are not gold stocks ‘paper gold’?..i am told that there is so much more gold ‘shares'(paper gold?) than actual gold, that eventually only those holding bullion will have anything worth having.

  • Mark

    Mining stocks aren’t paper gold becuase most miners get their hands on the physical metal and are able to sell as spot, which then translates into cash. I agree with Bengt concerning mining stocks and i should know as my junior mining stocks (that include a few producers) are woefully undervalued, having performed terribly of late despite the gold price rising. Take AAZ for instance, a well run company on target to produce more that 60000 oz gold this year with very low costs of around $400 oz. They have a market cap of around £50m and little debt that will be paid off this year. If metal prices stay this strong they could be on a PE of around 2 when final year results are announced! Now compare that to most other companies on the stockmarket. This is not an isolated example – there are dozens of very cheap miners that rake in more and more cash the higher gold goes. At some point the market will catch up and i intend to take full advantage!

  • Peter

    So what does this mean, that we should sell the physical gold in a few years? Thanks.

  • Krass

    I am wondering when the fundamentals for valuing precious metals are going to change. Or probably they already did? Even shoe-shine boys have invested in gold and silver.

  • Pete

    Is it a good idea to invest in gold mining ETFs? I know there is a regular charge on ETFs, but is it the easiest way to get exposure to the best gold miners?

    And I would bet that Soros has his own bullion vaults.

  • Will Hicks

    Pushing paper gold again. This really is getting boring now money week. Well blow me down, this “reflexive” market is generally known as a positive/negative feedback loop in a real mans profession like engineering.

  • Mikester

    How easy would be for the average punter to leverage into Gold? Physical as opposed to Mining stocks. As the Gold itself doesn’t provide a return….surely a world where people borrow multiples of salary to purchase Gold will not exist??!!
    Also if Gold went insane then that would require people pulling money out of banks, stocks, reduce capital for start up businesses etc. So not really a desirable outcome – ie governments may decide to intervene…..

  • Gord Tennant

    Bengt Saelensminde’s report rubbishing academics and favouring the reflexive markets is a bit like saying the medics have got it wrong and the health of the nation depends upon the weather! Sorry Bengt I accept George Soros may have been a good economist and that is why he made his fortunes – through acedemia not garbage statements that is more and more prevalent when the markets are correcting. GTEN

  • Beta Adjusted

    No Gord. I agree that Bengt could have made his case for why EMH is rubbish a lot better. But it is. There is no evidence for it and yet has been adopted as THE model in finance. It has some uses in terms of thinking about risk modelling and how to price derivatives which transformed the industry but beyond that it has done more harm than good. Economics is called ‘the dismal science’ for a reason. Look up Joe Piotroski, Robert Haugen, Robert Shiller etc. A nice, simple summary (not as good/thorough as the academic research however) is given in James Montier’s latest book Value Investing: Tools and Techniques for Intelligent Investment. A review of this stuff in Moneyweek might be a good idea (I could do it …)

  • Supermarine Blues

    I laughed out loud when I read Bengt’s comments yesterday – it fits with my own prejudices about economics. I still have my copy of Baumol & Blinder somewhere…

    Like many of those ‘alternative medicines’ that the gullible wasted their money on at the top of the boom, there’s an underlying element of truth in it, wrapped up in a load of old bollox by way of a job-creation exercise.

    BTW; there ARE mechanisms to leverage gold, just like anything else. Salesmen & shoe-shine boys were buying stocks on credit once & it’s a very real risk, since it’s hard to quantify.

  • David

    Shoe shine boys; are we back to the roaring 20s?

  • Supermarine Blues


    It depends who you ask; the early Kondratieff-wave followers would have you believe we are now in the early 1930s.

    Those who clain to have refined the K-wave into the Super Cycle would claim we are somewhere in the late 1940s/early 1950s.

    Those who believe in the 120-year Grand Super Cycle would claim it’s like the early 1890s and things are really, really bad indeed.

  • Jim C

    @Krass, the idea that even ‘shoeshine’ boys are invested in precious metals is absolute nonsense.

    The amount of money invested in PMs is tiny compared with other assets. At any dinner-party, mention gold or silver investing and people will politely change the subject… they haven’t a clue and, furthermore, think it’s the domain of kooks.

    Hardly anyone has PM investments. This (besides blatant bullion bank-led price suppression) is the reason why silver is so volatile – its a tiny market. Most of the leverage is by the shorts, incidentally.

    Anyone curious (or sceptical) about PM price suppression should pay a visit to gata.org, who have researched it extensively.

  • TomGramps

    Dear Colleagues, fellow worriers and investors,

    I agreed with GS’s sentiments when he 1st indicated he was selling his gold (guess 70% to 80% before he mentioned it). It wasn’t a surprise to me. Like a lesser .com the fringes of cowboy land, some time ago, cottoned on, set up their trading stalls in every town centre and have been making a “killing” ever since – there will be a bubble, it will burst, humpty dumpty and all the kings men…. etc. etc. GS got out very early perhaps, so did I – and there are other fish to fry.

    Being a Bear isn’t all bad!

  • SteveH

    @Jim C
    what please does PM stand for?

  • NRS

    It’s in the opening sentence – Precious Metals.

  • Davros

    Gold is not going up at all; its currencies that are being devalued due to money printing. Incidentally, I don’t believe Soros has sold all his gold, I think it’s his holdings in ETF’s not the physical.

  • flying fish

    Is this relevant, I am down to last 10.000(pounds) and have no other insurances, pensions etc due in the future. I am willing to risk 50% and fancy gold where do I start.I am a bit of a gambler but dont take risk lightheartedley. Anyone got any quick advice.I am a total novice (not even that good)