1) You hear me talk about this more than most, but liquidity risk needs more emphasis. This is true whether you are a retail or institutional investor. As the old saying goes, “Only invest what you can afford to lose.” The basic operations of life require liquidity.
That even applies to the abstract mathematicians who developed much of modern finance. The moment they assume a simple arbitrage argument, it implies that liquidity is free, or nearly so, in the markets. I remember asking questions of my professors over Black-Scholes 25 years ago, because equity markets did not trade continuously, except for large companies.
My view is that introducing liquidity risk will be difficult for academic finance, because it will blow apart the simple models that they need in order to write their research. Once markets do not trade continuously, the math gets tough.
2) Insiders are selling, should you worry? Perhaps a little, but I would wait until the price momentum starts to fail. Like value investors, insiders tend to be early.
3) What works in a time of rising leverage will not work well when leverage is decreasing. Or, a strategy that requires liquid markets does not so well in a time of deleveraging. Consider Citadel, then. The period from 1991-2007 was pretty care-free. What crises occurred were not systemic, and were quickly snuffed out by the Fed, as it edged us closer to a liquidity trap. In 2008, the trap was sprung and Citadel had a lousy year. Amid the carnage, they were forced to sell into falling market. Now they are running at reduced leverage, and planning products that would have been smart eight months ago.
4) Average retail investors don’t understand regulated investments well enough to invest in them. It would be stupid to allow them to invest in hedge funds, then. If we would do such a thing, then deregulate the simpler investments first, telling people that they are on their own, the ineffective SEC is being disbanded, and that “caveat emptor” is the only risk control remaining.
I can’t see that happening in my lifetime. The nature of American culture abhors implicit fraud, and thus we regulate most of those that take money and offer uncertain promises, when those offering the money don’t have much. (The culture abhors little investors being fleeced by bigger institutions.)
5) Auction rate preferred securities — when I was younger, I wondered how they worked. By the time I figured that out, the market failed. Now the lawsuits fly. Yes, they were marketed as money market equivalents, but none of them made it into money market funds. Now, having read many of the prospectuses, the risks that eventually emerged were disclosed in advance. Few believed them because it had worked so well for so long. My view is this — investors needed to read the “risk factors,” and did not. ARPS were designed to be investment vehicles that could survive a storm, but not a tornado. Tornadoes do happen, and those that assumed that such volatility would never happen lost.
6) My, but the high yield market and lower investment-grade corporate markets have moved higher. What observers miss is that yields for sensitive financials are a lot higher than they were in early 2007, about the time I started this blog. Systemic risk is still high.
8 ) After many other crises, junior debt gets grabbed when seniors have rallied a great deal. The need for yield is significant, much as I think it is premature to buy those junior debts.
9) The same is true for high yield. When does the rally end? Now? Typically near a market peak, there is confusion, and a diminution in volume. I think we are close to the end, but as I usually say, honor the momentum. If it is still going up, hold it.
10) This article is a little unusual for me, but it points out something that I often talk about in different terms. Trees don’t grow to the sky. In almost any process, the results are not linear as one increases effort, but there comes diminishing returns because improvement is not costless. Exponential growth meets the constraint that resources are not infinite, and so growth follows more of an S-curve. So it is with business, and much of finance.