“I am here to help you,” Robert said soothingly, as if speaking to a psychopath.
“Help me?” Gerhard laughed. “How can you help me?”
“By providing needed liquidity,” Robert asserted.
“You want to help us by providing needed liquidity?” the German chuckled gregariously. “That’s a good one!”
“Do you find that funny?” Robert asked.
“I am laughing, my American friend, because liquidity is nothing more than a function of finding a market clearing price. At the right price there is endless liquidity. And at an unattractive price there is no liquidity at all; liquidity is searching for value, but here in Germany there is no value, so there is no liquidity.”
— Excerpt from The Shipping Man by Matthew McCleery
We should have added a concluding passage to last week’s piece is, which is where we begin this week.
If interest rates are zero or negative, then capital markets gradually begin to approach ‘commodity like’ behaviour i.e. exhibiting negative cost of carry where returns are mostly price driven. When markets become more commodity like, monitoring the flows of capital and how market participants are positioned can begin to reveal the health of the market and can give one a measure of foresight that can support more successful navigation of markets. In such a market environment, in our opinion, monitoring liquidity and participant positioning is of outsized importance relative to fundamental and macroeconomic analysis.
The chart below compares our quarterly liquidity indicator plotted against the S&P 500 Index forward one quarter. (The scale for the liquidity indicator is not provided.)
The S&P 500 Index, in our opinion, fairly reflects the liquidity environment. The challenge for equity markets hereon is determining the next move in liquidity. The boost from supportive monetary policy is in the rear-view, and market-specific flows appear to be turning net negative.
This moderation in investment flows has occurred against a backdrop of upside surprises in both economic data and recent earnings announcements — reaffirming our thinking that ‘liquidity’ is the most important metric to try and track.
For now, assuming no further injections of liquidity volatility can be expected to increase in the run up to the Presidential election. This can be further exacerbated by market participants becoming sufficiently worried about Mr Biden’s plan to increase tax rates. Without further liquidity creation, we do not expect another significant leg up in the market till after the elections.
[As an aside, the one fallacy in our system of tracking liquidity is that it does not adjust for quality of liquidity. When the focus is increasingly on the quantity, in neglect of quality, inevitably quality deteriorates. Quality in this instance being the return on invested capital generated when the newly created liquidity is put to work.]
If there is increased volatility prior to the election, we wonder if the ‘smart money’ will rotate into stocks of those businesses most hurt by the pandemic? That is tilt their portfolios from ‘growth’ to ‘value’. And even if they do, will it matter as passive flows continue to dominate market activity?
We are of the opinion that the passive juggernaut will overwhelm any active rotation.
Brittleness
As names such as Tesla or of those of more fundamentally sound foundations such as Apple and Amazon continue to scale new heights, we are increasingly worried about the eventual brittleness of the market in face of a sell-off.
Below we share two passages from Michael J Mauboussin’s piece from “Who Is On The Other Side?” issued in February 2019, one quoting Mr Maboussin and the other quoting Professor Blake LeBaron, that capture our concerns around the potential brittleness of the US equity market.
“During the run-up to a crash, population diversity fails. Agents begin to use very similar trading strategies as their common good performance begins to self-reinforce. This makes the population very brittle, in that a small reduction in the demand for shares could have a strong destabilising impact on the market. The economic mechanism here is clear. Traders have a hard time finding Anyone to sell to in a falling market since everyone else is following very similar strategies. …this forces the price to drop by a large magnitude to clear the market. The population homogeneity translates into a reduction in market liquidity.”
— Blake LeBaron, Professor of International Economics in the Brandeis International Business School
“Crowding not only induces mispricing, it also creates a lack of liquidity. When the buyers are using the same rule and the population of sellers using different rules has nothing left to sell, the model reveals that the price has to drop sharply to clear the market. The non-linear relationship between diversity and price makes the sharp decline appear shocking in retrospect.”
— Michael J Mauboussin
For now, our prescription to manage for any potential brittleness is to hold positions in stocks of commodity producers but a more nuanced approach may be required than this. We hope to give that more that in the coming weeks.
Thank you for reading!
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.