The real danger this summer is a market-driven loss of liquidity. You’ll hear a lot of people worry about rising volatility. But that’s a red herring. Volatility itself is no bad thing.
As Avinash Persaud writes in the introduction to Liquidity Black Holes: “Volatility is a normal and necessary function of markets. Markets should adjust quickly to new information and, if the information is shocking enough, the adjustment will be volatile.” Traders live for these kinds of events. Fat tails…rare events…black swans. They create inefficiencies is market prices that you can take advantage of.
But sometimes they spiral quickly out of control. Persaud writes, “Our concern…is where episodes of high volatility reflect not a market adjustment to a more stable position, but a market disruption: where price changes no longer help to clear a market, but help destabilize it.” Anything can destabilize a market that is driven by mostly borrowed money. It can be a bad bet by a hedge fund or a big bomb by a maniac in Pyongyang. The cause of the crisis is often completely unanticipated. But the consequences are not: “Thus, in portfolio and banking markets, the system seizes up. No one player is willing — or indeed, able — to prevent the formation of a liquidity black hole once confidence has evaporated and a downward cycle has begun.”
Has the downward cycle begun? I’d say it began in 2000 in the Nasdaq and is sporadically but inexorably making its way through asset markets. The WLX chart shows you that asset markets can fall a lot further very quickly. For example, one-fifth of the companies in the WLX are financial stocks — exactly the kinds of stocks whose assets can disappear quickly in a liquidity crisis. The obvious and only important question for investors is this: What goes up when liquidity disappears? The answer is not as obvious.
Clearly, most stocks will go down. To the extent that all stocks are financial assets, any stock you own — regardless of the quality of the business or the earnings — is at risk in a liquidity crisis. There is one thing and one thing only that goes up when liquidity vanishes: volatility. In a liquidity black hole, you either want to be a seller of stocks or a buyer of volatility. Both strategies are trades. For conservative investors (I count myself in that category), a liquidity black hole is to be avoided like fish lying out in the sun. You don’t liquidate your portfolio or add to it. You wait for the black hole to do its work, and at the end of the crisis, you own the companies and the assets you believe have long-term real tangible value.
By Dan Denning in Strategic Investments
Category: Economics