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Entropy, which is a measure of disorder, is present in every aspect of our world. At a high level, it just means all things trend toward disorder.

Over the last twelve-plus years it’s been fascinating to watch the Federal Reserve struggle to defy the laws of nature through unconventional monetary policy and in the process, we believe, decrease the stability of the system.

The rationale for how the Fed got here is well-known. First, it was to save the system from complete collapse in the Global Financial Crisis (GFC). Then, they used it to stave off the scariest of all economic threats, deflation. Once the pandemic hit, markets were essentially Pavlov’s dog with a bell. The Federal Reserve’s manic focus attempted to combat the following: volatility, deflation, down markets, and stopping the failure of any systematic company. This has only increased the disorder/entropy in the system, not decreased it.

One way to look at entropy in a system is through an example. Think of a library. Let’s say I walk into my local library with my two small children. No doubt the second we step foot in the door, one starts crying and the other starts speaking loudly, usually explaining why the first one is crying. In this example, my kids are applying energy into very low energy (low entropy), stable system (the library). Now let’s say I take the same kids into Chuck E. Cheese, on a Friday! Their same crying and antics are hardly even noticed among the 50 other screaming kids playing loud games with flashing lights and a large rat walking around.

The energy my kids are applying to the system is the same for both the library and Chuck E. Cheese, but the efficiency with which that energy imposes a change in each respective system is vastly different.

Systems with stability (lower entropy) are more efficient and prone to change by the energy introduced. This is not a bad thing, it’s what is needed to make the necessary changes in the system to get back to a level of stability over the long run. The Fed’s experiments have degraded the efficiency of markets by increasing entropy, which means more and more energy is needed to efficiently deliver a signal and instigate change. Euphoric bubbles are the natural byproduct of the additional energy required. It’s like a superstar kid hitting 30 shots in a row on the pop-a-shot.

It’s very much the same in organizations and capital markets. Prior to this extended period of zero interest rates, organizations and markets (the system) were more like the library. Most companies made decisions based on rational economic factors that included a return on the capital they invested with a reasonable margin of safety.

Malinvestment without regard to risk resulted in Darwinian outcomes. Indexing through mutual funds and exchange traded funds (ETFs) and the giants such as BlackRock, Vanguard, and State Street who brought them to us, were $204 billion of global assets as of 2003 and had very little sway with management. In general, people knew what they were investing in during prior eras. The 1999-2000 tech bubble was still fresh in their psyche and resulted in a modicum of risk aversion. Investments had a real cost. SPACs were viewed with caution. From 2009 to 2017 there were a total of 122 IPO/SPACs.¹

Over the last decade-plus, much has changed. Companies have shifted their focus to financial engineering as the main return driver. Debt has been piled onto their balance sheets and used to buy back shares (with very little attention paid to valuation) versus economic investments. Organizations tout revenue and user growth as the key metrics to the health of a company. Any detractor to the linear progression of these new metrics was not tolerated by investors. Profits are not the concern; the focus is on the unlimited potential “in the future”. Risks have been costless, so no margin of safety is needed. ETFs are now 10 trillion of global equities.¹ It’s fair to say that most investors have zero clue about the companies they are invested in or their lack of diversification.

It’s hard to blame them. When everything goes up for more than a decade, do you really need to conduct due diligence on a company, take career risks by being outside the FANGs, or have an original thought outside of consensus? Markets and organizations have been anesthetized to the reality of risk. From 2018 to May of 2023 there have been 1,066 SPAC/IPOs.

This all makes logical sense. As entropy has grown, investors and organizations must expend even more energy to impose change into the system because of the “totality of it” as Charlie Munger says. Seth Klarman recently went on CNBC and warned about the “Everything Bubble”.² This bubble has included everything from Bitcoin, Dogecoin, Robinhood option strategies based on Reddit posts, and the top five companies in the S&P 500 accounting for 96% of gains this year, etc.

The Federal Reserve policies have not reduced entropy in the system, they have bolstered it and in order for change to be achieved, unfortunately, the signal/energy needed to effect that change must be greater. The alternative is for the Fed to hush.

We believe the market cycle we are now entering renders the margin of safety concept more important, not less, and this affords our particular investment strategy an advantage.

¹ Statista
² BusinessFormation.io

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