The Importance of Liquidity

This week a client asked me a great question in response to an investment that I recommended to him. He wanted to know how liquid the investment would be if the markets headed south. My answer to him, for this particular investment, was it matters why markets were crashing.

The stock market and the housing market are now both higher than they were in 2007 when the economy almost failed. The Great Recession started out as an economic slowdown marked by massive job losses, and then morphed into a liquidity event. Without the government bailout and subsequent money printing by the Federal Reserve, I highly doubt the economy would have rebounded as sharply as it did.

There have been a number of “flash crashes” in recent years, which were all the result of liquidity disappearing overnight. Other recent events included the BREXIT vote and the shock on election night when the markets woke up to the fact that Hillary would not be President.

On Wednesday, Bank of America rang a warning bell regarding all the money that has piled into passive exchange-traded funds. According to CNBC, “The bank says the massive popularity of ETFs may be leading us on a road to a liquidity problem. The note issued by Bank of America, Merrill Lynch’s Global Research department warns “the actual shares available, or true float for S&P 500 stocks, may be grossly overestimated. That could lead stocks and the overall market to fluctuate more violently, especially to the downside, due to a future event affecting either a single stock, a sector or the market at large.”  Joe Terranova, the chief market strategist for Virtus Investment Partners, which manages $25 billion, said, “The danger is when the market falls. Liquidity will evaporate.”

Here is another quote from the leading story in this week’s Barron’s Magazine – “We still call it a stock market, but these days it has many more indexes than it does stocks: There are nearly 6,000 indexes today, up from fewer than 1,000 a decade ago. Meanwhile, the number of stocks in the Wilshire 5000 Total Market Index has shriveled to 3,599, from 7,562 in 1998.”

Below is a chart from the same Barron’s article.

This is the #1 fear that is now very well understood by investors. The #2 fear is if interest rates become unstable and rise sharply. Since June 26th the 10-year Treasury yield has risen from 2.12% to 2.40%. The 10-year yield would need to go over 3% before investors take note. The #3 fear is best summed up with the following quote by Donald Rumsfeld, “…there are also unknown unknowns. There are things we don’t know we don’t know.” It’s the unknown event not anticipated by the market which will likely cause the next liquidity crisis.

It is difficult to predict when the distortion of the market causes a liquidity event. The Man vs. Machine debate will continue and it will only grow louder as passively managed funds gain more and more assets. If the popularity of indexing continues for years to come, I believe that it will be the computers that exacerbate the next market crisis. It is a very interesting debate and even concerns Vanguard founder Jack Bogle, who created the world’s first index fund. He warns, “the implications of this rapid trading in ETFs “have yet to be fully examined.” I believe that we might have to wait until interest rates are much higher before the implication of ETFs can be fully examined.

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