‘Tis an Illiquidity That Blows No Good

Uh-Oh! We’re Out of Market Liquidity!
[courtesy Google Images]

For example, Business Insider (“This week’s gold crash reminds us of a much scarier risk in the markets”) warned that on Monday, July 20^th,

“. . . 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?

No.

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?

Definitions

•  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.”

Say whut?

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.”

Description

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.”

Maybe illiquidity sometimes pushes us back towards reality and truth.

•  In October, A.D. 2007, the DJIA peaked at 14,198. By March, A.D. 2009, the DJIA had lost 54% of its value and hit a market low of 6,443.  That’s evidence of illiquidity.  But, was that fall completely irrational?  Or did it reflect the fact that the markets had been irrationally supported by the PPT for the previous 20 years and, as a result, the 14,000 Dow was 54% higher than fundamentals and the free market could justify?

Did 20 years of “Plunge Protection” protect us from a score of free-market mini-crashes that might’ve held Dow down around 7,000?  Did the Dow therefore rise artificially to 14,000?  Did the weight of all the mini-plunges that had been prevented by the PPT “accumulate” until they broke loose in a major crash in 2007-2009?

Since A.D. 2008, the Federal Reserve has injected over $3 trillion into US banks. It’s called Quantitative Easing (QE).  It’s fairly common knowledge that most of that $3 trillion has gone into the stock markets.  That $3 trillion has guaranteed market liquidity and pushed the Dow up from 6,443 to over 18,000.

How much of that 11,000 point rise was real and due to an economic “recovery”?

How much was illusory and based only on the PPT’s and Fed’s proviso of artificial liquidity where it might not otherwise exist?

•  Can our central planners “fool Mother Nature” indefinitely by injecting unlimited, artificial liquidity into the markets? The central planners act as if the answer is Yes.

But, isn’t it obvious that there must be an objective limit to how large our liquidity “bubbles” can grow before they pop?

When the liquidity “bubble” inevitably pops, will that be a bad thing?  Lots of investors will scream as they watch their “fortunes” disappear.  But, did they really have a “fortune”?  Or did they only have a paper illusion that was provided courtesy of the PPT’s and government’s promise that there’d always be market liquidity and so the market prices would always rise?

Illusions are lies.  Destroying illusions may be painful, but is it wrong?

Aren’t we all better off if we return to some semblance of truth?

Ask a silly question

We’ve seen some examples, descriptions and consequence of “liquidity” and “illiquidity”.  We’ve even seen some definitions that may be technically correct, but still seem hard to understand.

So, let’s see if I can provide working definitions of “liquidity” and “illiquidity” that might not be precisely accurate, but might still be useful.

The best way to find out what something mysterious is or means is to ask questions.  If you can frame and then answer the right questions, they’ll tend to lead you, step-by-step, to a workable explanation or definition.

For example, as Business Insider opined, the most accurate definition of “illiquidity” may be too highly “complex and nuanced” to ever be truly understood by the great unwashed.  But, for a simple country boy like me, a few questions can push us towards a fairly understandable and workable definition.

Let’s start with Business Insiders’ “broad” definition of “liquidity” as a premise and see if we can pick it apart with some questions:

“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.”

Q:  Why can’t people easily sell their investments during a time of “low liquidity”?

A:  Because the potential buyers prefer to hold their cash rather than buy that particular investment.

Q:  Why do potential buyers prefer to hold their cash?

A:  Because the value and purchasing power of their cash is rising.

Q:  Is there a commonly-understood, economic term that signifies circumstances when the purchasing power of cash is rising?

A:  Yes—“deflation”.

Implication:  “Low liquidity” and “illiquidity” are simply esoteric terms used to describe periods of deflation.

“Deflation” is usually a characteristic of an economic downturn, recession or, especially, a depression.

It follows that periods of “illiquidity” are consistent with deflation and economic depression.

Q:  Are brokers and economists going out of their way to provide multiple and esoteric definitions of “illiquidity” because the concept is so complex, subtle and confusing?

A:  I doubt it.  I suspect that the absence of a single, clear definition of those terms is evidence taht brokers and economists provide confusing and imprecise definitions of “illiquidity” to avoid saying the “D-words”:  “deflation” and, by implication, “depression”.

So long as the definitions of “low liquidity” and “illiquidity” are “complex and nuanced,” they’re unlikely to be understood by 99% of the American people.  So long as the majority don’t understand those words’ meanings, use of those words is unlikely to cause much panic.

If the public understood that “illiquidity” simply meant or implied “deflation” (and “deflation” was a hallmark of economic depression), every time the central planners said “Illiquidity,” the public would be more likely to panic, sell their stocks, and collapse the markets.

•  Economist’s use of words like “illiquidity” reminds me of parents in the 1950s who spoke in “pig Latin” to prevent their kids from knowing what Mom and Dad were up to. “Pig Latin” was achieved by moving the first letter of a word to the end of the word and attaching the “ay” sound.  For example, the word “dad” became “ad-day”; the world “mom” became “om-may”.  Parents might ask each other, “Ow-hay . . . oon-say . . . an-cay . . . e-way . . . ut-pay . . . e-thay . . . ittle-lay . . . onsters-may . . . o-tay . . . ed-bay?”  The kids wouldn’t understand and start whining about going to bed.

Similarly, today’s brokers and economists don’t want to scare the kids (investors) by saying the dreaded “D-words” ‘cuz that might sap investor “confidence”.  Sapping confidence is bad for “bidness”.  Therefore, brokers and economists instead use the “pig Latin” of economics to talk about “iquidity-lay”.

My definitions

It may be true that professional definitions of “liquidity” and “illiquidity” are far more “complex and nuanced” than the ones I’m offering.  Still, it’s also true that, in broad strokes, my definitions seem relatively simple (perhaps oversimplified) but understandable and workable:

“Liquidity” implies a period of inflation when prices are rising, dollars are losing value and people are happy to spend their cash on investments that will protect their wealth from inflation.  If the price of a new Cadillac is $50,000 today and likely to rise to $60,000 in the next quarter, you’d better buy that car now.  That’s inflation.  That’s liquidity.  For most practical purposes, “liquidity” means “inflation”.

“Illiquidity” corresponds to a period of deflation when prices are falling, dollars are gaining value, and people therefore refuse to spend them on investments that will expose their wealth to deflationary losses.  If the price of a new Cadillac is $50,000 today and likely to fall to $40,000 in the next quarter, you’d better hang onto your cash and postpone buying for a while.  That’s deflation.  That’s illiquidity.  For most practical purposes, “illiquidity” merely means “deflation”.

What’s in a name, hmm?

While “deflation” might cause panic, its apparent synonym—“illiquidity”—might not.

Q:  Was “pig Latin” invented by an economist?  Or was it a lawyer?

A:  Hard to say.

Q:  Are there any economic fundamentals–or is it all just word games?

A:  There are fundamentals that are powerful, irresistible and inevitable—but they’re obscured by the economists’ and government’s word games and won’t be manifest until the word games have been exposed and defeated.

Q:  Is “illiquidity” bad?

A:  It might be painful, but it’s not necessarily bad if you like free markets and truth.