What is Liquidity?
Many market commentators, myself included, have been talking about the amazing amount of liquidity in the markets. Caroline Baum wrote a piece recently asking what liquidity really was, and she did not draw any real conclusion, in my opinion. For someone as smart as Caroline Baum to not come to a conclusion, means the concept must be pretty tough.
Last week’s copy of The Economist took another stab at it, and here is the critical quotation:
Helpfully, Martin Barnes, of BCA Research, an economic research firm, has laid out three ways of looking at liquidity. The first has to do with overall monetary conditions: money supply, official interest rates and the price of credit. The second is the state of balance sheets—the share of money, or things that can be exchanged for it in a hurry, in the assets of firms, households and financial institutions. The third, financial-market liquidity, is close to the textbook definition: the ability to buy and sell securities without triggering big changes in prices.
Pretty good, but it could be better. These are correlated phenomena. Times of high liquidity exist when parties are willing to take on fixed commitments for seemingly low rewards. Credit spreads are tight. Credit is growing more rapidly than the monetary base. Banks are willing to lend at relatively low spreads over Treasuries. Same for corporate bond investors. And, if you are trying to generate income by selling options, it almost doesn’t matter what market you are trading. Implied volatilities are low, so you realize less premium, while giving up flexibility (or, liquidity).
The demographics of the developed world favor saving over spending, given the given the graying of the Baby Boomers. Given that the excess credit is heading for the financial markets, and not to the goods markets, we are getting asset price inflation, but not goods price inflation. Spreads tighten, implied volatilities drop, and companies get bought out of the public markets, and get levered up in the private markets. The excess of credit also lowers the costs of carrying assets, which in turn leads to more trading, and bid/ask spreads tighten.
In short, what we are faced with is a situation where there is increasing leverage among market intermediaries in order to earn high returns off of assets with low unlevered returns. This cannot persist indefinitely, and when it reverses, the markets will be ugly. This is why you should insist on high quality stocks and bonds in this market environment. When the willingness to take risk diminishes, the low quality stuff will get killed.
February 22nd, 20071:30 pm at
I have been a big fan of your columns at realmoney and I think it is great you are starting this blog!
Great post on liquidity. My short-term stock trading canary in the coalmine is the the smallcap Russel value vs. Russel growth index. In the intermediate term, I look at the emerging markets currencies (not the stock prices) as my experience has shown the speculative curriencies to be superb leading indicators (granted my experience is only a few years, but I am an adaptive kind of guy). Notice how hard the Brazilian Real sold off in May of last year. The fact that it hardly corrected at all during pullbacks in September and January gave me the conviction to aggressively buy the dips.
Are there any other indicators you look at besides credit spreads, CDS and option premiums? Have you ever tried to create a composite risk appetite model?
Finally, one other tidbit that may or may not be of interest. I like to look into the internals of the markets, and in early August, the ratio of stocks in the Russell 3000 with historical volatility >60/
February 22nd, 20071:58 pm at
Thanks for the kind words.As to other indicators, I would point you to my article http://www.thestreet.com/p/_rms/rmoney/davidmerkel/10136569.html“>The Fundamentals of Market Tops. That has my tops indicators, minus a few. Perhaps I can do a more generalized post on indicators.
Oh, and no, I don’t have a composite indicator… I work more by “feel.” Different indicators are more important in different cycles. I suspect that CDS spreads and FX may be more critical in this one. Where would one find the ratio of stocks in the Russell 3000 with historical volatility >60? Sounds interesting.February 22nd, 20072:02 pm at
the last part of my post chopped off here -
Finally, one other tidbit that may or may not be of interest. I like to look into the internals of the markets, and in early August, the ratio of stocks in the Russell 3000 with historical volatility >60/
February 22nd, 20072:04 pm at
>60 vs