Billionaire financier George Soros this month repeated his warning gold is locked in the “ultimate bubble”, and told investors bluntly it was “certainly not safe” in troubled times.

Soros was simply repeating a warning he issued at the World Economic Forum (WEF) back in February. At the time gold was trading at less than $1,150 per ounce. It has since risen to touch $1,300 this week, and is up more than 400 percent from its low of $252 in 1999. There is no end in sight for the bull run. Anyone who shorted gold back in February would be sitting on huge losses.

But while Soros himself warned gold was in a bubble, his hedge fund, Soros Fund Management LLC was one of the biggest gold bulls of the year, doubling its holding of shares in the SPDR Gold Trust at about the same time he was issuing his warning at the WEF in Davos.

Soros is no longer involved in the management of the fund. But the apparent disconnect between the bubble warning and the bullishness of his fund will strike many observers as strange. In reality it illustrates the fascinating investment philosophy of one of the most successful financiers of the last 50 years and is the best way to understand what is really going on in the precious metal market.

REFLEXIVITY AND BUBBLES

Soros outlined his theory of price formation, and how bubbles inflate and collapse, in a brilliant book on “The Alchemy of Finance”, first published in 1987, but updated in 2003. It remains one of the clearest, most incisive explanations of how and why bubbles occur, and shows how profiting from the “madness of crowds” has been pivotal to his success.

In particular, Soros rejected the prevailing idea that “market prices are … passive reflections of the underlying fundamentals”, a dogma he dismissed as market fundamentalism, or that there were stabilizing forces which would automatically drive prices back towards equilibrium.

Instead, Soros propounded a theory of “reflexivity”, in which fundamentals shape perceptions and prices, but prices and perceptions also shape fundamentals. Instead of a one-way, linear relationship in which causality flows from fundamentals to prices and perceptions, Soros developed the theory of a loop in which prices, fundamentals and perceptions all act on one another.

“I contend that financial markets are always wrong in the sense that they operate with a prevailing bias, but that the bias can actually validate itself by influencing not only market prices but also the fundamentals that market prices are supposed to reflect”.

Later he writes more bluntly: “[The efficient market hypothesis and theory of rational expectations] claims that the markets are always right; my proposition is that markets are almost always wrong but often they can validate themselves”.

Beyond a certain point, self-reinforcing feedback loops become unsustainable. But in the meantime positive feedback causes bubbles to inflate further and for longer than anyone could have foreseen at the outset.

“Typically, a self-reinforcing process undergoes orderly corrections in the early stages, and, if it survives them, the bias tends to be reinforced, and is less easily shaken. When the process is advanced, corrections become scarcer and the danger of a climactic reversal greater”.

RUNNING WITH THE HERD

Soros cites numerous examples of self-validating behavior — ranging from the conglomerate boom of the 1960s and real estate investment trusts (REITs) in the 1970s to the technology boom and the rise and spectacular fall of Enron and WorldCom at the end of the 1990s and start of the 2000s. Each was heralded at the time as a “new paradigm”.

But none is more fascinating than his explanation of the dynamics of the REITs bubble in the early 1970s. Because Soros recognized the potential for a bubble early and published a research note advocating investors should get aboard the trend.

In his note he sketched the entire rise and fall of the REITs in the form of a four act play, warning that eventually disappointment would affect valuation and lead to a shakeout, with fewer new entries, more regulation and more moderate growth.

But he observed “The shakeout is a long time away. Before it occurs, mortgage trusts will have grown manifold in size and mortgage trust shares will have shown tremendous gains. It is not a danger that should deter investors at the present time. The only real danger at present is that the self-reinforcing process may not get underway at all”.

In the debate about whether markets are a “weighing machine” for discovering true fundamental value or a “voting machine” which records the popularity of certain theories and the mass of the crowd, Soros came down firmly on the side of the voting machine.

Crucially, the successful speculator responds to bubbles not by shorting them and waiting for stabilizing forces to drive the market quickly back to some fundamental value, but by identifying them early and riding the wave, hoping to get out before the whole edifice finally comes crashing down.

Reading people (other investors, narratives) is as important — if not more important — as understanding the fundamentals of an asset itself. Identifying the next “new new thing” earlier than the rest of the crowd and getting aboard, and then being willing to liquidate before the deluge, is at the heart of the speculator’s success.

GOLD AS ULTIMATE BUBBLE

In this world, gold is the ultimate bubble because apart from the cost of actually digging it out of the ground it has almost no real fundamentals other than price itself. Investors have been buying it precisely because the price has been going up and is expected to carry on rising. Rising prices have created their own demand. It is the ultimately reflexive investment.

Rising gold prices have encouraged investors to add gold to their portfolios and central banks to reverse a long-standing drift towards eliminating the low-yielding asset from their reserves and start adding it instead.

In a thoughtful research note, Deutsche Bank argues that “the gold market is still some way from displaying the characteristics of a bubble” (Commodities Quarterly, Sep 28). But using the Soros idea of a bubble as a process, rather than simply a frothy end-state, gold has already been a bubble for some time as an ever larger group of investors has climbed aboard, propelling prices higher.

In an implicit acknowledgment of the role self-validating forces have played driving gold prices higher, one prominent gold analyst recently pointed out that gold still has the most compelling “narrative” of any investment.

In a research note, Barclays Capital explains “For analysts … gold has traditionally been a tricky one due to its multiple roles as a commodity, currency, inflation hedge and hedge against credit risk and macroeconomic uncertainty. Gold is, in sum, more than a simple commodity, it’s a hedge against fear” (Commodity Daily Briefing, Sep 23). Barclays might have added a hedge against deflation as well, another function cited by Deutsche Bank.

But with so many apparent fundamentals, in some sense it has none at all; gold is the ultimate voting asset, which is valuable precisely because other investors believe it is valuable.

Soros was right to identify it back in February as the ultimate bubble. And his hedge fund was even more right to brush aside fundamental concerns and go long.