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A New Beginning with the Second Law of Thermodynamics

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On the New Year’s Day, I opened the first chapter of the book of 2019, called ‘Opportunity’.

Seneca the Younger, a Roman philosopher said, “every new beginning comes from some other beginning’s end”. The series of changes in 2018 paved the way of a new beginning for us with overwhelming response from Investment Advisors and Certified Financial Planners ( CFPs) to our goals-based investing approach and practical use of behavioral finance in asset management.

This is very timely with the market disorder that started in the last quarter of 2018. As 2019 rolls in, with Happy New Year, I want to thank the Advisors and CFPs who have entrusted us to deliver Behaviorally Adapted Models (BAM) for their clients.

We are thrilled and also pleasantly surprised to see how reducing Entropy helped us achieve a greater success in a short period of time. This is known as the Second Law of Thermodynamics. I also think Entropy (the amount of disorder) in global economy and markets is responsible for shaking investors’ confidence in the last quarter.

The Second Law of Thermodynamics teaches us that it is the natural tendency of things to lose order. Whether it be the human consumption and digestion of food, a humming auto engine or cooling of a hot cup of coffee, the rate of Entropy content continually increases while the potential continually decreases over time. Entropy is a measure of disorder, and there is a natural progress toward maximum Entropy for any isolated system. Entropy is also a measure of energy that cannot be used for useful work. So if a system has higher Entropy, there’s less energy available for useful work, and if the system has lower Entropy, there’s more energy available for work.

Left to only time, life becomes less structured and disorderly. Houses get cluttered, cars begin to rust and weeds overtake gardens. It is a part of our common experience. Spend hours cleaning your desk, basement, or attic, and it seems to spontaneously revert back to disorder and chaos before your eyes. And, it requires energy to bring the order back in the system, which does not happen spontaneously.

Too much of good things e.g. easy monetary policy for long sowed the seeds of “financial bubbles” that has introduced huge Entropy in the financial system, which has caused great damage to the US economy over the past 20 years. This signifies over-dependence of the US market and economy on easy monetary policy of the Federal Reserve (Fed) as Stephen Roach remarked in his recent article, In Defense of the Fed,

“And so it went, from bubble to bubble. The more the real economy became dependent on the asset economy, the tougher it became for the Fed to break the daisy chain. Until now. Predictably, the current equity market rout has left many aghast that the Fed would dare continue its current normalization campaign.”

At its inception, the Fed, faced with the deepest economic downturn since the Great Depression, justifiably embarked on a plan to reduce interest rates towards zero and to infuse massive amounts of liquidity into the economy through what is known as “Quantitative Easing (QE)”. It did so with the objective of engineering an escape velocity in the economic system and, in turn, a self-sustaining recovery. Over time, it simply increased Entropy in the economic system. At the outset of the emergence from the recession of 2008, the Federal Reserve’s policy actions were necessary to stabilize the domestic economy and the world’s financial system but as time went by, there were signposts of moderate US economic growth, which warranted the beginning of a tightening cycle sooner. But the Fed embarked on a forward guidance that kept on changing….

The training wheels may be needed when someone learns to ride a bicycle, but the continuing support of training wheels can cause lacking self-confidence of a 12-year old.  The benefits of “free money” from the Fed thus began to lose their positive marginal impact on energizing economic growth and have begun to sow the seeds of potential problems of Entropy “down the road”, which Stephen Roach alluded from Ben Bernanke and Mark Gertler’s working paper,

“while monetary policy was far too blunt an instrument to prevent asset-bubbles, the Fed’s tools were far more effective in cleaning up the mess after they burst.”

We now stand more than ten years from the collapse of global growth and the “Black Swan” decline of the US stock market in 2008. At best, monetary policy has been arguably providing Entropy in the system, which is evident from the following charts of Federal funds rate, real GDP growth, unemployment rate and consumer confidence over the last 20 years.

We hope, the markets going forward, would be driven by economic fundamentals, not an Entropy-driven monetary policy.  Mohamed El-Erian used the metaphor of an airplane  “changing engines while flying at a high altitude” to indicate a shift from a liquidity-driven market to a fundamentally-driven market. That’s the new beginning in 2019 with the Second Law of Thermodynamics.

Related: Flight or Fight the Market by Sticking to Your Guns?

The inevitable trend is that things become less organized over time and it takes efforts and energy to gets things orderly again. However, all aspects of Entropy are not always positive, or otherwise, it would’ve meant chaos or disorder must continually grow with time. Negative Entropy (creating order) may result in from harnessing information gained in an event or a process, which could transform “wasted energy” to work. This is called Enthalpy, or the overall energy gained in a system by adding the internal energy and the energy of overcoming pressure by utilizing negative entropy. For example, Enthalpy is the energy created by using a rubber band with pressure to hold a bunch of pencils to prevent scattering after taking them out of a box, or putting black and white marbles in separate jars to create an order.

With the chaos of financial markets, advisors, CFPs are having a difficult time dealing with their clients’ questions, stress and anxieties. We have used the concept of Enthalpy in our Behaviorally Adapted Models (BAM) to reduce Entropy to control disorder and confusion with the financial markets by harnessing the information from economy and markets, and layering-in investors’ goals and behavioral biases in a smart way.

My New Year’s resolution is to continue creating Enthalpy by boosting the power of Dynamic Risk Management with the energy of Behaviorally Adapted Models.  Let’s keep reading together, the first chapter of the 2019 book, ‘Opportunity’ on this New Year’s Day.

Happy New Year!

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This post is for informational purposes only and is not to be considered a recommendation to buy or sell a security or service.  Convex Capital Management LLC (“Convex Capital”) utilizes best efforts to ensure the content displayed herein is from sources believed to be reliable and accurate, but makes no representation thereof and accepts no liability or any loss arising from use or reliance of any of the information herein.  The opinions expressed are a reflection of Convex Capital Management’s best judgment at the time this report is compiled, and any obligation to update or alter forward-looking statement as a result of new information, future events, or otherwise is disclaimed.  There is no guarantee that Convex Capital has not changed its research views after the blog-post is published.
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