Why The Market WON’T Bounce Right Back

It is unrealistic to think that the market will rise as rapidly as it has fallen and it is unlikely that the market has hit the bottom yet. At the beginning of the year, the leading indicators were vastly overvalued at an average price to earnings (P/E) ratio of nearly 25 within the S&P 500, which is a company’s current share price with regard to its current per-share earnings (1). This P/E ratio was higher than it had been in nearly a decade. Once a recession begins (and yes, that is happening now), it takes time to build back to previous highs.

Entropy

Narrowing secular passive investment trends have been the key to such a steady march upwards over the last decade. This increasingly polarized investment trend of passively directing stock purchase towards large cap companies has stifled critical price discovery achieved through fundamental security level analysis. We are now transitioning into highly volatile times as the market advances from a “low entropy state” to a “high entropy state”.

Let me explain what I mean by “entropy” a little better. Over the past decade, individual investing strategies have become increasingly correlated with one another. This simply means that your investment allocations, the individual companies you implicitly own, have likely been very similar to that of the person standing next to you. Moving forward in time, that correlation will diminish as investor strategies diverge through a process of seeking more adequately valued or undervalued assets. This is just the way I choose to describe it given my engineering background.

Individual Retirement Savings Plans (think 401k)

Herding individual investors into retirement savings plans (with few options in the way of true investment autonomy) has created a beast. Not only has it created the beast, it only provides the investor with a narrow spread of options which are, in effect, now a volatility engine with the ability to rebalance asset classes from anywhere rapidly.

Available Liquidity

There isn’t enough investor money in the market at present to bring it back to January 2020 levels. Over the past month, much destruction has already occurred to capital and valuations are down. That is, the perceived money that exists within people’s investments has been drastically decreased for the time being because demand is far lower than it was in January of this year. Further, because of the current health crisis, banks are receiving a much smaller amount of interest on the loans they have created. This concept not only applies to indivuals, but also extends to many levereged corporations.

The Fed

The Federal Reserve has been propping up lending institutions (banks) and these banks have extended vast amounts of credit to an unknown number of companies since the great recession (the means by which this has been accomplished is complicated and outside the focus of this article). The Fed’s easing will now need to be aimed more directly to the common people of this country instead of those who own vast amounts of wealth. That means instead of executive officers focusing on share buybacks like they have been in the past, the new focus will be on simply keeping their companies solvent.

Conclusion

The assumption that the market, as most people gauge it, will bounce right back after COVID-19 presupposes that investor sentiments will suddenly merge in harmony. This is not likely to happen. We are at the opening gates of a very necessary investor paradigm shift. Fortunately, we are poised much better than in 2008 and 2000.

References

Also note the Shiller PE ratio https://www.longtermtrends.net/price-earnings-ratio/

2. https://hiddenforces.io/wp-content/uploads/2020/02/Rundown-Ep.122-FINAL-The-Allegory-of-the-Hawk-and-Serpent-Chris-Cole-1.pdf

3. https://www.bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos