Order, Disorder, Disruptive Events and a Bubble

If you’ve been paying attention, you might have noticed the stock market has entered some exciting new territory during the global coronavirus pandemic. To understand how exciting, let’s revisit some basic concepts for what defines order, disorder, disruptive events, and bubbles as they apply to stock prices.

Order exists in a market whenever the change in the price of assets in the market are closely coupled with the change in the income that might be realized from owning or holding the assets, within a band of approximately normal variation about a central tendency.

Disorder exists in a market whenever the change in the price of assets in the market is not coupled with the change in the income that might be realized from owning or holding the assets within a band of approximately normal variation about a central tendency that would describe the relationship between the two when order exists in the market.

A disruptive event may be said to be taking place whenever a significant change in the price of assets in the market is not coupled with the change in the income that might be realized from owning or holding the assets over a limited period of time.

And finally, a bubble exists whenever the price of an asset that may be freely exchanged in a well-established market first soars then plummets over a sustained period of time at rates that are decoupled from the rate of growth of the income that might be realized from owning or holding the asset.

Now, let’s look at the history of the S&P 500 (Index: SPX), as measured against its underlying dividends per share, or rather, the income that might be realized from owning or holding shares of an S&P 500 index fund or its component firms in your investing portfolio, from December 1991 through the nearly complete month of July 2020, which shows all of these things.

The action corresponding to the coronavirus pandemic is contained in the upper right hand corner of this chart. Following a period of relative order that ran from December 2018 through February 2020, the onset of the coronavirus pandemic in the U.S. in March 2020 represents both a disruptive event, which sent stock prices plunging into a new period of relative disorder.

That plunge reversed when the U.S. Federal Reserve initiated an unprecedented level of intervention to stabilize markets in late March 2020, flooding them with liquidity that succeeded in boosting stock prices in a bid to prevent the greater economic damage that would otherwise have resulted from a collapse in the value of these assets.

But far from stabilizing the situation in the market, by definition, the Fed has effectively blown a new bubble in stock prices, as seen by the rapid ascent of the S&P 500 that is decoupled from the index’ underlying trailing year dividends per share, which have begun to fall after having stalled in the second quarter of 2020.

In nominal terms, the size of the bubble that has been inflated in the four months since March 2020 is a little smaller than the inflation phase of the Dot Com Bubble, which took far longer to inflate back in the period from April 1997 through August 2000.

It seems in this exciting new territory for the S&P 500, stock prices are reacting more to changes in the expected rate of growth of the Fed’s balance sheet than they are to changes in the expected rate of growth of the S&P 500′s underlying dividends per share.

How long that might last is anyone’s guess. The only thing we know for certain is that eventually, all periods of relative order, disorder, disruptive events, or bubbles in the stock market come to an end. It’s only ever a question of when.