by John R. Goltermann, CFA, CPA, CGMA
October 11, 2018
10 years after the panicky bottom of 2008’s bear market, investors have experienced a massive bull run in equities that brought a quadrupling in US stock prices over a relatively short period of time. With this backdrop – and with big back to back declines in stock prices – now seems like a good time to pause and reflect on the idea of reflexivity in markets.
Reflexivity refers to the self-reinforcing effects of market behavior, whereby rising prices create optimism, attract more buyers, causing further gains, causing people to feel wealthier, borrow more and so on until the process becomes unsustainable and reverses. The idea of reflexivity has been around for 100 years. In markets, George Soros credits his understanding of it and investor behavior as being the key to his success.
Reflexivity is the idea that market prices in and of themselves create economic behaviors such as real estate lending. Banks tend to ease lending standards while prices rise and tighten their standards when prices fall, which magnifies and extends the real estate markets’ related booms and busts. Reflexive behavior causes prices to rise and fall in greater magnitude and for longer than the general equilibrium theory dictates they should.
In present times, the 2008 crisis prompted the Fed to intervene by way of bank rescues and zero interest rates. This caused the flow of credit to start up again. The severe asset price decline in 2008 – 2009 also caused pensions to be significantly underfunded, leading them to invest in credit instruments (bonds, loans and pools of bonds and loans), which affected the real economy through easing lending standards and with institutional investors using cheap loans to buy up assets. Corporations borrowed trillions to buy back their own stock, which became a major source of market liquidity for 10 years.
The problem now with stock buybacks, and hence market liquidity, is that the ability to juice earnings per share (EPS) deteriorates with rising rates. Consider an all-equity company that trades with a $1 billion market cap and earns $20 million (a price-earnings ratio of 50). All things equal, if the company buys back $100 million of stock during a time when cash earns 2%, there is no accretion to earnings per share. Why? Because it is now a $900 million company that earns $18 million (earnings are $18 million because it lost the 2% earnings on the $100 million of cash it used for the buyback). It still has a PE of 50.
So high PE companies get no boost to their PE ratio (a dubious measurement anyway but important to some investors). Despite this, buybacks surged in the 1st half of 2018, up 43% (Source: Forbes) mostly due to the one-time effect of tax cuts. And it has been high PE companies that have been doing much of the buybacks in the recent past (according to CNBC, tech companies have done over 40% of buybacks in the last year).
So, a major source of market liquidity could very well decline, making this a riskier environment in general. This is not a great period to own speculative stocks, overpay for shares, use leverage, or be overly aggressive in your equity allocations as the risk backdrop has increased. With a potential sentiment change on the heels of a big down day, this is an excellent time to check your asset allocations to ensure that the funds you have invested in stocks are truly for the long term, and that the stocks you own are of good quality and trade at attractive prices. If you own solid investments that are priced reasonably, down days like the last two days are to be largely ignored.
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 General equilibrium dictates that markets always move towards equilibrium and that non-equilibrium fluctuations are merely random noise.