Booms and busts are not symmetrical because, at the inception of a boom, both the volume of credit and the value of the collateral are at a minimum; at the time of the bust, both are maximum. But there is another factor at play. The liquidation of loans takes time; the faster it has to be accomplished, the greater the effect on the value of the collateral...The amazing thing is that the reflexive connection between lending and collateral has not been generally recognized.

Source:   The Alchemy of Finance

The assertion that future outcomes are fully reflected in current expectations seems absurd, yet it is very much alive. It is at the basis of the prevailing paradigm in financial economics. Market prices are seen as passive reflections of the underlying fundamentals. The efficient market hypothesis claims that market prices fully reflect all extant information. The closely related rational expectations theory holds that, in the absence of exogenous shocks, financial markets tend toward an equilibrium that accurately reflects the participants' expectations. Together, these theories support the belief that financial markets, left to their own devices, assure the optimum allocation of resources. This paradigm is in deep trouble: the idea that financial markets tend toward such an equilibrium seems to be contradicted by the evidence. Most economists now recognize that financial markets are capable of producing multiple equilibria. Yet the idea that free, unregulated markets assure the optimum allocation of resources has not been abandoned. Great efforts have gone into reconciling the actual behavior of financial markets with the efficient market hypothesis, adopting ever more elastic definitions of rationality and ever more modest definitions of efficiency. These modifications do not go far enough. It is time for a paradigm shift.

Source:   The Alchemy of Finance

We live in the real world, but our view of the world does not correspond to the real world. The theory of rational expectations itself provides a striking example of how far our interpretation can stray from the real world. Yet our view of the world is part of the real world - we are participants. And the gap between reality and our interpretation of it introduces an element of uncertainty into the real world. Again, this sounds like circular reasoning, but it accurately describes situations with thinking participants.

Source:   The Alchemy of Finance

Instead of drawing dichotomies between thinking and reality, we must recognize that thinking forms part of reality instead of being separate from it…In other words, reality always exceeds our capacity to understand it [like Gödel's theorem]

Source:   The Alchemy of Finance

In a pure exchange, equilibrium has a clearly defined meaning: it is the price that clears the markets. When it applied to financial markets, equilibrium becomes more like a theological concept: it is the price that ought to clear the markets if market prices did not have any effect on the participants' attitudes and/or the fundamentals. But it is the nature of financial markets that they do have such effects. Consequently financial markets often develop boom/bust sequences and other far-from-equilibrium conditions.

Source:   The Alchemy of Finance

A strong case can be made that the slavish imitation of natural science has led economic theory down the wrong path. In their search for universally valid generalizations, economists largely ignored the complexities and uncertainties of the real world and constructed an elegant axiomatic structure based on unrealistic assumptions. The assumptions underlying perfect competition include perfect information, homogenous commodities, a large number of participants engaged in profit-maximizing behavior, and no transaction costs. The contention that unregulated financial markets lead to optimum allocation of resources rests on the assumption that participants base their decision on rational expectations. None of these assumptions prevail in the real world. The edifice that has been erected on these unsound foundations is extremely fragile...Remove even a few of the assumptions, and the edifice comes crashing down.

Source:   The Alchemy of Finance

The thinking of the active participant is very different from that of the outside observer. We may call it "organic" as distinct from rational. Scientists are interested in timeless generalizations and statistical probabilities; participants need to focus on the one particular case in which they are participating. Probabilities and generalizations can be useful, but they are misleading if they are based on the viewpoint of the outside observer. That is what happened in economic theory.

Source:   The Alchemy of Finance

…the financial markets offer an excellent laboratory for the pursuit of truth. The reason is to be found not only in the quantitative and public character of the data but even more in the emotional reality of financial markets…Playing the markets is about as real as a game can get. There is, of course, a divergence between expectations and outcomes, but the outcome has an inexorable quality about it.

Source:   The Alchemy of Finance

Existing theories about the behavior of stock prices are remarkably inadequate. They are of so little value to the practitioner that I am not even fully familiar with them. The fact that I could get by without them speaks for itself. Generally theories fall into two categories: fundamentalist and technical. More recently, the random walk theory has come into vogue; this theory holds that the market fully discounts all future developments so that the individual participant's chances of over- or underperforming the market as a whole are even. This line of argument has served as the theoretical justification for the increasing number of institutions that invest their money in index funds. The theory is manifestly false - I have disproved it by consistently outperforming the averages over a period of twelve years. Institutions may be well advised to invest in index funds rather than making specific investment decisions, but the reason to be found is in their substandard performance, not in the impossibility of outperforming the averages.

Source:   The Alchemy of Finance

Technical Analysis studies market patterns and the demand and supply of stocks. It has undoubted merit in predicting probabilities but not the actual course of events…it has little theoretical foundation other than the assertions that stock prices are determined by their supply and demand and that past experience is relevant in predicting the future.

Source:   The Alchemy of Finance

Fundamental Analysis is more interesting because it is an out-growth of the equilibrium theory. Stocks are supposed to have a true or fundamental value distinct from their current market price. The fundamental value of a stock may be defined either in relation to the earning power of the underlying assets or in relation to the fundamental value of other stocks. In either case, the market price of a stock is supposed to tend toward its fundamental value over a period of time so that the analysis of fundamental values provided a useful guide to investment decisions...[But] the possibility that stock market developments may affect the fortunes [earning power] of the companies is left out of account...Stock market valuations have a direct way of influencing underlying values: through the issue and repurchase of shares and options and through corporate transactions of all kinds...

Source:   The Alchemy of Finance

…I replace the assertion that markets are always right with two others: 1) Markets are always biased in one direction or the other. 2) Markets can influence the events that they anticipate.

Source:   The Alchemy of Finance

In any case, a "reflexive" model cannot take the place of fundamental analysis: all it can do is to provide an ingredient that is missing from it. In principle, the two approaches could be reconciled. Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values. One provides a static picture, the other a dynamic one.

Source:   The Alchemy of Finance

There seems to be a special affinity between reflexivity and credit. That is hardly surprising: credit depends on expectations; expectations involve bias; hence credit is one of the main avenues the permit bias to play a causal role in the course of events. But there is more to it. Credit seems to be associated with a particular kind of reflexive pattern that is known as boom and bust. The pattern is asymmetrical: the boom is drawn out and accelerates gradually; the bust is sudden and often catastrophic.

Source:   The Alchemy of Finance

Valuation is supposed to be a passive relationship in which the value reflects the underlying asset; but in this case [of credit] it involves a positive act: a loan is made. The act of lending may affect the collateral value: that is the connection that gives rise to a reflexive process.

Source:   The Alchemy of Finance

If participants labor under the misapprehension that the market is always right, the feedback they get is misleading. Indeed, the belief in efficient markets renders markets more unstable by short-circuiting the corrective process that would occur if participants recognized that markets are always biased. The more the theory of efficient markets is believed, the less efficient the markets become.

Source:   The Alchemy of Finance

People participate in science with a variety of motivations. For present purposes we may distinguish between two main objectives: the pursuit of truth and the pursuit of what we may call "operational success". In natural science, the two objectives coincide: true statements work better than false ones. Not so in social sciences: false ideas may be effective because of their influence on people's behavior and, conversely, the fact that a theory or prediction works does not provide conclusive evidence of its validity. Marxism provides an outstanding example of the first kind of divergence...The divergence between truth and operational or experimental success undermines scientific method in more ways than one. On the one hand, it renders scientific theories to achieve operational success. What is worse, an alchemical theory can profit from assuming a scientific guise.

Source:   The Alchemy of Finance

[Gary] Gladstein, who has worked closely with Soros for fifteen years, describes his boss as operating in almost mystical terms, tying Soros’s expertise to his ability to visualize the entire world’s money and credit flows. “He has the macro vision of the entire world. He consumes all this information, digests it all, and from there he can come out with his opinion as to how this is going to be sorted out. He’ll look at charts, but most of the information he’s processing is verbal, not statistical.”

Source:   More Than You Know