April 2021 – Liquidity Drought
As investors watch the Federal Reserve continue its stunning balance sheet expansion, the financial media often touts how the US central bank is “flooding the markets with liquidity.” Is this really the case? Are stocks making new highs in every month so far in 2021 on heavy buy volume from all this “printed money?” Rather than speculate, we prefer real-world examples, and the blowup of the Archegos Family Office is an excellent counterargument to the “flooded with liquidity” thesis.
Quoted Prices Cannot Absorb Large Sales
When motivated sellers enter the markets, there is no liquidity at current prices. As Archegos received margin calls, stocks like Viacom and Discovery Holdings suffered quick, 50% declines in their trading prices. As you can see in the chart below, low volume had the stock drifting upwards, but once a high volume transaction needed to take place, there were no buyers at the current price. There are compelling reasons to believe the liquidity profile for the other companies in the S&P 500 are just as pitiful.
It’s An Isolated Event, Don’t Worry
Some commentators have marveled at how the broader market ignored the thrashing in Discovery, Viacom, and other companies as a result of the margin call. Additionally, Credit Suisse announced a $4.7 billion loss as a result, which is more than 10% of their balance sheet equity, but thankfully there appears to be no signs of contagion among the large banks. Is everything OK? Is this just an isolated event? The below chart says otherwise.
Liquidity Liquidity Everywhere and Not a Drop to Drink
The above chart shows investors’ response to Federal Reserve balance sheet expansion: “The Fed will not allow prolonged stock market declines, so buy aggressively with borrowed money.” Margin debt as a percentage of nominal GDP is higher than the previous two market peaks in March of 2000 and July 2007. Both of those bear markets happened while the Federal Reserve cut interest rates, failing to arrest the decline. Instead, the bear markets became prolonged and painful as over-leveraged investors were forced to sell, overwhelming buyers at prevailing prices. What happened with Archegos is merely a symptom of an overextended system. When you consider Archegos used swaps, which are not a reported form of leverage in the above chart, perhaps it is time to reconsider aggressive allocations to equities.
Liquidity is a coward, it disappears at the first sign of trouble.
Wall Street adage
An old Wall Street saying is: “liquidity is a coward, it disappears at the first sign of trouble.” Margin debt has destabilized the system, and only when these numbers decline as a percentage of GDP will fragility abate. Until then, expect more events like Archegos, but with an increasing probability for contagion. Fundamentally, as more and more retirees are forced to sell through required minimum distributions (waived in 2020 but returning in 2021,) we believe the limited buy-side liquidity will also be overwhelmed by sellers – at scale, across every stock. Instead of marveling at spectacular past performance, we strongly encourage investors to look at the fundamentals backing this performance. Many companies are trading at record high valuations not because of compelling growth opportunities, but because low liquidity enables a small amount of buyers to push prices up daily. Be wary of what happens when forced sellers enter the auction.