Liquidity and volatility: deciphering the market jargon

“Liquidity” and “volatility” are constantly tossed about by the financial media and Wall Street as if everyone fully understands them and their importance. These terms are essential, but unfortunately few investment professionals take the time to help investors fully appreciate them.

Mea culpa! We also use the terms extensively in our writing and podcasts, but fail to impress their importance on our subscribers.

With volatility skyrocketing and the Fed removing liquidity, we think now is the perfect time to discuss the two terms and their dependence on each other. We hope this broader understanding of volatility and liquidity will help you better appreciate risk conditions.

Liquidity

  • The Fed injects $70.2 billion of short-term liquidity into the markets.” – WSJ December 2019
  • Is it a liquidity crisis or a solvency crisis? It matters to the Fed.” WSJ April 2020
  • Liquidity Shocks: Lessons from the Global Financial Crisis.” NYT August 2021

These headlines are just a few of the many ways the media uses the word liquidity.

Liquidity is the fuel that drives the engine of the financial market. Thus, without sufficient liquidity, the engine seizes up and financial crises break out.

Liquidity refers to the amount of money investors are willing to use to buy and sell assets now. As you might guess, the more investors willing to bid and offer assets, the more liquid the market. We can’t underline or underline the word “AND” enough. Liquid markets must have many bidders and bidders of an asset at the same time.

Consider markets in which only one side of the market offered good liquidity.

In 2008, everyone was selling subprime mortgages, while buyers were rare. In late 2020 and early 2021, buyers of SPAC, meme stocks, cryptocurrencies and an assortment of high-growth tech stocks eclipsed the number of sellers.

The 2008 example highlights a surplus of sellers with limited buyers. The most recent example is the opposite. Looking back, we know how the two illiquid conditions ultimately ended. This is why it is essential that a liquid market has enough buyers and sellers.

Liquidity is in the eye of the trader

At the time of writing this article, Apple’s stock price is 160.12. Currently, 350 shares are offered at 160.13 and 500 are offered at 160.11. At less than five cents off the current price, well over 7,500 shares are offered and offered. As a result, for a retail investor looking to buy or sell 20 shares, Apple’s market is incredibly liquid. A trade of 20 shares will be at market price and will have no effect on the market.

Warren Buffett’s Berkshire Hathaway owns around 1 billion shares of Apple. If Buffett feels like selling even a small portion of his billion shares as soon as possible, he might have a different view of Apple’s liquidity.

The point of comparing these two views on liquidity is to highlight the importance of assessing how current liquidity conditions affect your trading, but equally important to understand liquidity in a broader sense. The Warren Buffett of the investment world is dictating Apple’s price, not our 20-stock trader! Therefore, if Mr. Buffett is desperate to sell, he will likely have to rely on bidders at lower prices. Then, the amount of the price concession is a function of the amount of existing liquidity.

Liquidity defines risk!

Volatility

Volatility is often cited in two ways, realized and implied.

Realized, or historical, volatility is retrospective. It is a statistical measure of the price movement of an asset over a previous period.

Implied volatility is derived from option prices. It is a measure of what investors think the volatility will be in the future.

Although calculated differently, gauges quantify price movement, past and expected. Also, and a story for another article, the difference between them can sometimes be eye-opening.

More importantly, volatility is not just a mathematical calculation. Volatility measures liquidity! And liquidity defines risk.

Volatility measures liquidity

Liquidity is variable. Changes in sentiment or policies, for example, can quickly alter liquidity. When liquidity is high, many buyers and sellers are willing to act at or very close to current market prices.

As we discussed in our previous example, selling or buying 20 shares of Apple, even if done repeatedly, will have little or no effect on the price. In such an environment, the price will move up and down as the factors change, but the movement will be gradual.

Now consider a market in which every purchase of 20 shares of Apple moves the stock a penny or more. Under these circumstances, liquidity is low and prices are sensitive to a motivated buyer or seller. In such cases, the daily price movements at Apple are much higher than in the liquid market example. As a result, Warren Buffett could easily introduce significant downward pressure in such a market.

This example shows how liquidity is the key determinant of volatility.

Proof

To help cement the concept better, we provide real data.

The CME chart below shows the S&P 500 E-mini futures price (blue) and its accounting depth (red and green). Booking depth measures the number of deals and offers, on average, available. As you can see, when the markets are rising, accounting depth is more important. A deeper book implies that investors are more comfortable, willing and able to offer liquidity.

The second chart shows that the uptrend from April to December 2021 had relatively low levels of realized and implied volatility. In January 2022, the markets began to decline and liquidity gave way. During this period, the depth of the book weakened and volatility readings increased.

annualized realized volatility comparison of implied volatility s&p 500 index

Fed liquidity role

Liquidity comes from investors who are willing and able to buy and sell. Consequently, sentiment, monetary and fiscal policy, and a host of other factors affect investors’ willingness and ability. Over the past 20 years, the Fed has played an increasingly important role in regulating liquidity.

The Federal Reserve directly provides and does not provide liquidity. Under QE, the Fed buys and sells bonds. In doing so, they add or remove securities available on the markets. Deleting assets increases liquidity because the amount of investable dollars chases less assets.

However, and just as important, is the Fed’s indirect influence on liquidity. This happens via the perception that the Fed is adding or reducing liquidity and supporting or not supporting the markets. Investors feel more comfortable knowing that the Fed is adding liquidity. As we have seen many times, the Fed’s liquidity is an excellent safety net for many investors. Conversely, as we see now, anxiety tends to occur when they withdraw cash.

Rising and falling interest rates are another way they affect liquidity. Trading using margin increases the buying power of buyers and sellers. Higher interest rates make it more expensive to buy assets on margin and vice versa for lower rates. The chart below from Jesse Felder (the Felder Report) shows that margin debt (leveraged speculation) tends to peak at market highs and troughs near market lows.

leveraged speculation in stock chart

Finally, the Fed regulates the banks. Accordingly, its rules and restrictions affect capital and collateral requirements, which directly influence the volume of financial market assets that banks can hold and/or lend.

Summary – Don’t Fight the Fed

We often say, “don’t fight the Fed”. What we mean is that when the Fed provides liquidity, don’t fight it. Fed liquidity is likely to appease investors and create a less risky environment. Fed liquidity emboldens investors and adds liquidity, even when valuations are extreme.

Conversely and incredibly important today, when the Fed withdraws liquidity, don’t be shy.Worries are heightened, resulting in reduced market depth and increased volatility.

There is no sign that the Fed’s current quest to eliminate liquidity is about to end. We recommend that you carefully consider that liquidity is fading because of the Fed and therefore volatility is on the rise. Illiquid and volatile markets are not conducive to long-term wealth creation.

Twitter: @michaellebowitz

The author or his company may have positions in the titles mentioned at the time of publication. Any opinions expressed herein are solely those of the author and in no way represent the views or opinions of any other person or entity.

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