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Apri 19, 2000

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Devangshu Datta

Reflex action

Reflexivity: The two-way connection (in financial markets) between present decisions and future events.

Which is, The Crisis of Global Capitalism by legendary investor George Soros explains helpfully, a concept developed by him by adapting some concepts of philosopher Karl Popper with special regard to self-referencing. In essence, it means that Soros believes that the price paid for a certain asset now may affect the future fortunes of that asset in a variety of ways - a self-referencing feedback mechanism.

Is this gobbledygook? Just think of two companies A and B with the same turnovers, growth rates, cash flows and twin brothers as CEOs. A has a market valuation that is double that of B - A benefits in a variety of ways. It has more and cheaper options of raising cash. And, it may compensate its employees with less in the way of cash outflows via employee stock option plans (ESOPs). What's more it could fund acquisitions via a stock swap route - in the extreme case, it can take over B and double its size with a 1:2 buyout ratio.

All these things have happened, though not of course with such symmetry. ESOPs are a dime a dozen in high-tech, high-touch industries. According to a McKinsey study, ESOPs can be skewed as high as 80-90 per cent of total employee compensation for a successful start-up. Ratios of 75 per cent are not uncommon and 55 per cent is normal.

As to acquisitions - just think of America Online (AOL). In the merger with Time-Warner, AOL took a discount to market value in merging equities at a 1:1 ratio. AOL has approximately a tenth of the profits and turnover of Time-Warner, although it has faster growth rates. Prior to the TW-AOL merger, AOL also bought out Netscape, paying for the deal in stock.

So let us accept the first point of reflexivity. Current prices may affect the future fortunes of financial assets. The second point, according to Soros, is that reflexivity is a self-reinforcing mechanism. When things are going well and valuations are high, things get better and better. Until finally, prices get way out of line and much higher than valuations. When, on the other hand, things get bearish, prices tend to drop and drop - until they are way out of line with valuations again.

Most market theorists believe in the concept of equilibrium - but Soros thinks equilibrium is a rarity in an open market system. Events tend to bear him out. Market valuations are rarely fully priced, they are always too high or too low.

Soros himself has benefited many times from over-correction - in the Wall Street Crash of 1987, in the collapse of the exchange rate mechanism when his Quantum Fund hammered the lira and the sterling, and in the Asian Flu of 1996. He also lost huge sums when the rouble collapsed while he was long on Russian debt. In each case, reflexivity provided a better theoretical framework for ground reality than equilibrium.

In the last ten years, the American markets have gained continuously; especially, tech stocks on the NASDAQ. In many cases, valuations now appear wildly optimistic. Companies with no earnings and years of accumulated losses trade for billions of dollars. In the last week, NASDAQ lost 35 per cent. This week, tech stocks have already bounced back with NASDAQ rising 11 per cent in two strong sessions.

But this hiccup could still be the beginning of the end for the long bull market. In which case, reflexivity may take hold in the ensuing correction. Valuations will not just be pushed down to "fair levels", they will probably be hammered down much further than justified. This could have a sequence of strange fallouts.

One obvious fallout is an erosion of venture capitalist confidence. The NASDAQ strike-rate for IPOs is low - 89 per cent of stocks trade below issue price a year down the line. This suggests that the average company goes public at very juicy valuations. An opaque bookbuilding procedure and the release of stocks in driblets of 10 per cent ramp up IPO prices initially.

High IPO price expectations are why VCs fund risky start-ups - in the hope of profitable exits. If the secondary market slides, so do IPO prices. The Business Standard ICE Index, which pertains to Indian infotech, communication and entertainment stocks, reckons that unquoted valuations have corrected 41 per cent from mid-February highs, while quoted stocks have corrected 39 per cent.

If IPO prices slide, VCs fund fewer start-ups. Even second tranche funding is affected for companies, which have got off the ground and not yet gone public. A straw in the wind is the news that a lot of companies in the queue for NASDAQ ADRs are holding off until conditions stabilise.

Another possible fallout is more macro. If ESOPs turn to waste paper, how many high-tech workers will stick for current compensation structures? Even if they do, what happens to companies that funded overheads, mergers, acquisitions and associate programs using stock options as surrogate currency? Presumably, on a smaller scale, the same things that happen to countries that suffer currency collapse.

The third fallout is even bigger. America runs a big trade deficit and also a negative consumer savings rate. This has kept global GDP up since the Asian Flu when Alan Greenspan bravely cut rates to encourage US spending. Through last year, the Fed raised rates by 25 basis points per quarter. The US economy roared on regardless with GDP registering quarterly growth rates of 5 per cent plus. Finally, America shows signs of overheating - rising inflation, tight labour markets etc.

If the stock market now collapses, American consumer spending will shrink. The trade deficit will drop and the global engine will slow without the American consumer. This will affect economies everywhere. Europe and Japan are in no shape to even counter-balance an American slowdown.

A horror story? Maybe it won't happen this time. The NASDAQ does, after all, have an established habit of bouncing to higher highs after a violent retraction. But any market will reverse trend sooner or later. At that time, let us hope that reflexivity doesn't induce a serious global recession. It won't if Europe and Japan have picked up by the time the American bull market breaks.

Devangshu Datta

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