[Image Caption/Credit: Uh-Oh! We’re Out of Market Liquidity! (courtesy Google Images)]
Financial and economic news increasingly report on the term “liquidity” and its antonyms “low liquidity” and “illiquidity”.
For example, Business Insider (“This week’s gold crash reminds us of a much scarier risk in the markets”) warned that on Monday, July 20th,
“. . . gold crashed by more than 3% in just a matter of seconds. . . . [E]xperts are still trying to come to a consensus over the cause of the stunning move. . . . But all of these theories are more or less tied to one theme . . .: low liquidity. . . .
“Current concerns in the financial markets center around the absence of liquidity and the effect it might have on future market prices,” Janus’ Bill Gross said in June. “In 2008/2009, markets experienced not only a Minsky moment but a liquidity implosion . . . .
“Liquidity is a concept that is universal in the markets. And sometimes it will just vanish without warning. . . .”
“Low liquidity is bad almost any way you look at it.”
OK, OK, OK—the concept of “liquidity” is “universal” and, like a magician’s assistant, it can mysteriously vanish or appear at any moment. “Low liquidity” is universally bad and therefore an “ill” liquidity—or, for short, “illiquidity”.
We get that.
And we sure don’t want another “liquidity implosion”—do we?
In fact, we’re all united in our adamant opposition to “low liquidity”—but what th’ heck is it that we’re all opposed to?
What, exactly, do the terms “liquidity” and “illiquidity” mean?
• The Telegraph quoted the IMF as defining liquidity as,
“The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.”
I didn’t quite get that. The definition was a tad too “professional” for me.
• Business Insider defined “liquidity” as follows:
“Broadly speaking, liquidity measures how easily traders and investors can buy and sell an asset in the market without seeing big price dislocations. When liquidity is low, selling can cause prices to plummet.”
“Oaktree Capital’s Howard Marks offered a . . . philosophical definition: “The key criterion isn’t ‘can you sell it?’ It’s ‘can you sell it at a price equal or close to the last price?‘ For them [investments] to be truly liquid in this latter sense, one has to be able to move them promptly and without the imposition of a material discount.”
“Deutsche Bank’s Peter Hooper said, ‘. . . there is no single best metric for the level of liquidity in a market.”
Maybe, “liquidity” is like obscenity: economists can’t exactly define it, but they know it when they see it.
“Not only is liquidity underappreciated, but it’s also much more complex and nuanced than in the above definition.”
Everyone seems to agree that low liquidity or “illiquidity” is a problem (even a threat), but there doesn’t seem to be much agreement on what “liquidity” and its antithesis “illiquidity” really mean.
However, “in broad strokes,” adequate liquidity describes market circumstances where sellers can:
1) Easily sell whatever investments they’re holding; and
2) Not cause their investment’s price to fall as a consequence of the sale.
As an hypothetical example, suppose I owned $1 million in GM stock and I wanted to sell it. In a highly liquid market, I could “easily sell” my stock for the full price (more or less the $1 million I’d invested in GM)—and, the stock’s market price would stay at $1 million.
But if the market was illiquid, I’d have a hard time finding a buyer at any price, and when I found one, he’d want a significant discount. I.e., he might offer me only $800,000 for my $1 million in stock. Illiquidity would cause me to suffer a big loss.
More, illiquidity is contagious. If I accepted that $800,000 offer in a low liquidity market, the stock’s former price of $1 million could “officially” fall to $800,000 for all subsequent sales of that stock. Thus, in an illiquid market, if I accepted $800,000 for my $1 million investment, and if you’d also invested $1 million in GM and wanted to sell, you would also have to accept the $800,000 price (and $200,000 loss) that I’d previously accepted. By accepting $800,000 I could have caused the market price to fall by 20%.
Worse, if low liquidity persisted, the next guy who tried to sell what had formerly been $1 million worth of stock, might only hope to sell at $800,000. When he tried to sell, the few buyers who’d consider his offer might refuse to pay more than $600,000. (That’s a 40% loss.)
Being contagious, illiquidity can not only cause dramatic price declines, it can thereby precipitate panic among those still holding the GM stock. When the price is falling dramatically, everyone will want to sell. Almost no one will buy. The last guy to sell his $1 million in GM stock might be lucky to get $100,000.
It’s not so hard to provide a description of how illiquidity operates, but we still don’t have a workable definition.
Meet the PPT
The “Plunge Protection Team” (PPT; Working Group on Financial Markets) was created during the Reagan administration to protect the markets against the dangers of illiquidity.
During a period of illiquidity, if market prices started to fall, no one would be willing to buy at or near current prices and market prices would tend to “plunge” further towards annihilation. To stop such sudden and catastrophic episodes of illiquidity, the Plunge Protection Team (PPT) would enter the market and start purchasing the falling stocks with government funds. By purchasing the falling stocks, they’d provide liquidity (it would be easy to sell stocks without causing further prices declines) and stop the panic.
During the A.D. 2007-2009 Great Recession, the Federal Reserve stepped into falling markets to purchase “toxic assets” at full face value and thereby prevent the prices of those stocks or bonds from crashing. By making it “easy” for investors to sell (dump) their “toxic assets,” the Fed provided market liquidity that prevented the markets from remaining illiquid and crashing.
The concept of government providing “liquidity” is a great idea. Investors are thereby protected from catastrophic crashes that almost totally destroy investments’ value. The PPT acts as the markets’ insurance agent. They virtually “guarantee” that investors can’t lose everything during a market decline.
• However, there’s a problem. By establishing the PPT in A.D. 1988 (when the DJIA was about 2,100 points), the government created an artificial support for the markets. That support removed much of the risk in investing by implicitly guaranteeing that the markets could not fall significantly.
As seen in the market crash of A.D.2007-2008, that “guarantee” hasn’t been foolproof.
Still, given the PPT’s and the government’s determination to provide market liquidity, we’re left to wonder how much of today’s 17,000 points in the DJIA is real (due to free market fundamentals) and how much is illusory and due to market manipulation (artificial support) by the government, Fed and/or PPT.
The DJIA is up about 15,000 points since the creation of the PPT. How much of that 15,000-point gain would’ve taken place without the PPT? Without the PPT’s 27 years of protection against market illiquidity and market price crashes, would a truly “free” (unmanipulated) DJIA still be 17,000? Or would it be 8,000? Or, maybe, 5,000?
So long as the PPT is on guard, stocks can’t (usually) fall. The inability to fall can be expected to have caused stocks to rise irrationally. From that perspective, government’s guaranteed liquidity programs provide artificially, irrationally high market prices.
Over-priced stocks are a hallmark of investment “bubbles”.
Government’s and the PPT’s effort to inject artificial liquidity into the markets result in large, perhaps massive, “bubbles”.
Illiquidity, on the other hand, pops bubbles and pushes market prices down from artificial highs to levels that may be at or even below, rational free-market prices.
From this perspective, maybe it’s not true that ““Low liquidity is bad almost any way you look at it.”
Written by Alfred Adask
Full report at Adask’s Law
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