Liquidity - the asset class that's never there when you need it

August 26, 2021

12:30 am

 

  • The closer one is to the business end of the financial markets, the more important the issue of liquidity. At the business end, one is buying and selling financial instruments. When asking someone what the term liquidity means, one usually gets a response voiced in the first person, along the lines of ‘liquidity means me being able to get my trade done without moving the market more than I’d expect given the size of the order and the urgency’, or words to that effect.

  • By focusing on liquidity as a phenomenon in the first person (what ‘I’ can do in the market), we perhaps start to see why liquidity is one of those things which is never there when you really need it. As the old saying goes, the market won’t trade itself, and therefore rather than looking at the problem from the first-person (‘I’ or ‘me’) perspective, one ought really to look at it from the second-person perspective, focusing on the me-you relationship.

  • Liquidity is an issue which only seems to grab the attention of the market (and the media) during periods of crisis, and this almost inevitably means when asset prices are for the most part falling sharply. In this sense it is really an illiquidity problem, not a liquidity one – when one can’t get one’s execution done without moving the market adversely given the size of the trade. As such, it is usually a situation where everyone is trying to head for the exit at the same time, creating the feeling that the door is always far too small.
  • If liquidity is only one of those things that matters when it’s not there, how does one define it? One can look at the symptoms of illiquidity say (lack of order-book depth, a wide bid/ask, large price jumps on low trading volumes), but this is different to defining liquidity. It is a similar problem to defining what the adjective ‘healthy’ really means; one could say healthy means not being extremely underweight or overweight, but the BMI guidelines are just that – most of the England rugby team would be obese if the BMI rules were strictly applied, and clearly that isn’t the case. Likewise, ‘healthy’ skin usually just means the absence of blemishes or other disfigurements, and this is very different from saying someone is of the sort of model-like good looks to walk for Chanel at London Fashion Week.

 

  • Rather than necessarily trying to find a quantitative definition for liquidity (market depth, tight bid/ask and so forth), one might be better served by looking at the experience of markets themselves and then asking the question ‘why is this experience liquid and that one not?’ To do this, it is necessary to shift from the first person (‘I’) to the second person (‘you’), based on the idea that it takes at the very least two people to make a market.

 

  • Generally speaking, to effect a bargain in the market, two market participants have to agree on a price. Whatever the motivation, the buyer generally has to think the price will go up in the future, the seller that it will fall, all else equal. The motivation may be hedging, asset allocation, speculation or any number of other of reasons, none of which strictly matter. What is important is that the two market participants have to agree on an asset price to trade but at the same time disagree on the future asset value – the buyer thinks the value will rise, the seller that it will fall.

  • In this context, one can come up with a definition of liquidity based on what people actually do when they trade – they agree on a price to create a bargain, but this agreement on price is motivated by a disagreement on value. Liquidity as such is therefore the degree of willingness with which market participants express their implicit disagreement with one another with respect to value. The more they disagree at a certain price, the more they are willing to trade (i.e. bigger sizes) – the more the market is liquid. Liquidity is therefore a sign of healthy disagreement in markets and belies the idea of market economies reflecting a plurality of interests and opinions.

 

  • This may seem a bit abstract, but it is of direct relevance not only to day-to-day trading but longer-term considerations relating to investment and asset allocation. If a liquid market is one characterised by healthy disagreement reflecting a plurality of views, then an illiquid one is one where we would expect to see falling volumes, which in turn would indicate a high degree of consensus characteristic of over-confidence at the highs or excessive pessimism at the lows.

 

  • The graph below helps to illustrate the issue. The blue line is the SPDR S&P500 ETF trust (ticker SPY), with the red line showing the average daily volume of trust units traded, with data going back to January 2018. The big volume spikes during sell offs (the red peaks) stand out. If one were simply looking at trading volumes as a reflection of liquidity, sell-offs ought to be the most liquid period in the market cycle. Clearly this is the exact opposite of the trading experience – sell offs are periods of huge dislocation, forced liquidations due to margin calls and so on, and these are usually periods when liquidity feels like it is at its worst. How do we reconcile this apparent paradox?

Source: Bloomberg, as at 2nd August 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • The answer lies in volatility. At the market peaks in the SPY graph above, generally trading volumes are low, reflection apathy, agreement and what in retrospect turned out to be complacency. At these points, implied volatility as a measure of market risk is usually at the lows. This can be seen in the graph below of the VIX volatility index, the levels of which are driven by the same S&P index from which the SPDR ETF prices. The sell off and higher trading volumes in SPDR are accompanied by a short but intense period of volatility which are characterised by spikes in the VIX index.

Source: Bloomberg, as at 2nd August 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

 

  • The problem of high volumes, high volatility and the sense of illiquidity (despite the high volumes) can all be reconciled by going back to this idea of a market being made by participants who agree on price but disagree on value. What is happening in a market sell off or crash is a large number of market participants changing their mind about value all at the same time (i.e. that the market is over-valued all of a sudden), but where there is a corresponding absence of market participants coming in to buy thinking there is good value at current price levels.

  • This is basically why markets crash – they take the stairs up and the elevator down. This isn’t just the loss aversion theory from behavioural finance which suggest investors dislike losses more than they like making gains. In recent decades, the issue of leverage in the market has intensified market crashes as margin calls increase the deleveraging, exaggerating the sell off. It doesn’t necessarily matter why people change their mind about valuation, the important fact is that it tends to happen all at once. Wanting to sell and needing to sell get bundled together on the offer side of the market in a panic.

  • Judging whether a market is becoming illiquid and whether this period of illiquidity will then give way to a major price correction (these are two separate things) is as much art as it is science. In addition to the measures already mentioned (trading volume, bid/ask spread etc), there are other ‘market internals’ which include the ratio of stocks in an index hitting new highs, how these stocks are trading against their own moving averages and so on. There is of course valuation. The graph below shows the S&P 500 trading at a P/E of 27.5x, high by any historical standard. In terms of value, this graph shows there are clearly a lot of folk out there, whether actively or passively, who agree not only that stocks have done well, but more importantly given the high P/E, that they will continue to do so. This is the high degree of consensus that belies a state of market illiquidity.

Source: Bloomberg, as at 2nd August 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • A high P/E on the S&P 500 and low summer trading volumes don’t in themselves mean one should dump equities – this isn’t necessarily a market timing tool. Yet following the ‘everything rally’ in which a number of asset classes (including bonds, credit, equities and perhaps housing in some markets) are arguably in bubbles, then looking at liquidity as an asset class in itself, which can be valued and traded, may be a vital way of defending one’s long-term investment returns and spending power. This is especially true given the low yields on offer in the bond market.

  • How does one get long liquidity as an asset class? Since defining liquidity as something where people disagree about value but agree on price is a fairly abstract idea, just buying put options is clearly not the answer. The approach requires both qualitative and quantitative analysis, full of contingencies based on the economic and credit cycle, government and central bank policy, as well as a number of other factors.

  • What is clear though is after a monster equity and credit rally since March 2020, and with bond yields near the all-time lows, the usual ‘defences’ against a market reversal (buying bonds in anticipation of rate cuts) won’t be much help this time as policy rates are still stuck at or around zero. With parts of the global macro data set showing if not an actual slow down at least a waning in growth, it is probably a good time for investors to start assessing their options, and one way of doing this is to start thinking about liquidity. While you don’t have to be long, you definitely don’t want to be short liquidity if the market rolls over.

Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 12th August 2021. 

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