Investment liquidity: perception and reality
It can be easy to measure, but it also can be a desert mirage
How much liquidity do you have in your retirement and investment accounts? Is it adequate? These seem like straightforward questions that should lead to equally straightforward answers.
Yet answers can be as elusive as trying to correctly calculate the ebbs and flows of currency and foreign markets.
When markets behave normally, we assume that liquidity is easy to measure. When markets throw temper tantrums, well, we know liquidity can be a desert mirage.
The unexpected departure in late September of a “star” trader at a large mutual fund complex led to market distortions that rattled the $42 trillion government bond market. Bonds and shorter-term U.S. government obligations are typically considered the most “liquid” in the world. Even inflation-protected and low-risk U.S. bonds were briefly treated like a bargain bin item at the local dollar store. Corporate bonds, including the high-yield segment, also displayed noticeable pricing distortions.
In other words, at the time sellers and buyers shared a simultaneously low regard in their underlying liquidity and value. A month later, on Oct. 15, additional market distortions appeared that both rattled the stock market and created a dramatic spike in bond prices and the resulting dramatic drop in interest rates. The 10-year Treasury note began 2014 at slightly over 3 percent and gapped well below 2 percent as bond prices rose dramatically in mid-October.
Bond market tremors come and go, but recent events provide a good lesson in perspective.
In 2000, just before the tech bubble burst for good, Warren Buffet said in a letter to shareholders that “the line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money.”
Usually after a lengthy period of “effortless money,” such as the tech bubble in the late 1990s or the housing bubble of the mid-2000s, the reckoning can come with a vengeance. What seemed so certain one day, such as limitless liquidity and confidence, can evaporate quickly – whether it be in the perceived value of one’s house or more liquid government bonds.
Lesson of perception
We are rapidly approaching the seventh anniversary of when the investment bank of Bear Stearns went belly up in remarkably quick fashion as the first casualty of the subprime housing market.
There were many structural reasons why Bear Stearns collapsed in March 2008, but perhaps the most fundamental reason, namely “perception,” was diagnosed by 19th century British economist Walter Bagehot: “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit has gone.”
That lesson of perception also applied to Lehman Brothers in September 2008. Lehman Brothers was considered far stronger than Bear Stearns, but it imploded with equal results.
Ironically, both Bear Stearns and Lehman Brothers had relatively small asset investments in the subprime mortgage market when they collapsed. Lehman had even raised large amounts of capital in the weeks before it went bankrupt. But the perception of illiquidity was enough to create a crisis that became the reality of illiquidity.
For example, nothing is liquid when markets seize up or close due to events such as the 9/11 terrorist attacks. There are no buyers or sellers, and institutions reflexively become risk-averse when corporate debt and cash markets dry up so a larger credit crunch can follow.
Understanding the true value of one’s assets is as important as having diversity of assets. Exchange Traded Funds, or ETFs, have become exceptionally popular. They are investment products designed to be more easily bought and sold than individually purchasing the basket of securities that underlie the product.
But ETF trading prices and activity may be hard to ascertain because the underlying values of the assets (individual stocks or bonds) depend on a wide range of variables, including the most basic: are there sufficient buyers for the ETF’s underlying stocks? If not, the liquidity is more perceived than actual. How can an ETF be “liquid” if the holdings inside the product have not traded for weeks, or sometimes months? This is particularly a concern for me in areas relating to high-yield (aka “junk”) and foreign bonds.
My point isn’t to frighten anyone away from investing because an instrument may be opaque. We should, however, truly understand the liquidity, both real and perceived, of one’s assets. Maintaining adequate liquidity according to one’s risk threshold and goals is a smart goal.
Understanding the real nature of liquidity can be an even smarter one.
Tom Sedoric, managing director-investments of the Sedoric Group of Wells Fargo Advisors in Portsmouth, can be reached at 603-430-8000 or thesedoricgroup.com.