In a previous article, entitled “Avoiding the perils of the ‘drawdown’”, I explored the concept of ‘drawdowns’, the heavy losses that are the consequences of these episodes and some ways for reducing their impact. In this article, I will discuss the relationship between drawdowns and liquidity, based on the works of John Maynard Keynes and Nassim Taleb and lessons drawn from the 1987 and 2007 financial crises.
What is liquidity?
An asset’s liquidity is the extent to which it can bought or sold quickly without the transaction having a major impact on its price. This characteristic is the function of two dimensions: facility of conversion and loss of value. In his work The General Theory of Employment, Interest and Money, Keynes stressed the importance of liquidity, which investors seek out for various reasons, including speculation, precaution or transaction. However, liquidity traps may also appear. These are temporary events involving a security or market that suspend the traditional equilibrium between buyers and sellers.
To Taleb, author of the book The Black Swan, liquidity is like a movie theatre: “The market is a large movie theatre with a small door.” When the audience walks in, it does so gradually as some of them arrive earlier than others. But when it’s time to leave, things can get tight, since the spectators all want to leave at the same time, and a funnel forms at the exit.
How have drawdowns and liquidity interacted in the past?
On several occasions in the past, such as in 1987 and, more recently, in 2008, liquidity dried up in certain asset classes, leading to major drawdowns.
On 19 October 1987, the Dow Jones dropped more than 25%. This day, which has come to be known as “Black Monday” remains its worst-ever single-day loss. Mark Carlson of the US Federal Reserve has studied this crisis and offered some possible explanations for this liquidity trap.
First of all, the US economy was emerging from a multi-year expansion. Companies were becoming overvalued and oil market pressures generated a spike in inflation. Yields of 10-year Treasury notes rose until October, from 7.22% to 10.23%. On 19 October, the announcement of a heavy trade deficit triggered a rush for the exits. Portfolio insurance strategies that had spread throughout the financial markets over several years were then forced to sell. These strategies served as a catalyst and exacerbated the amplitude of the correction.
More recently, in 2008, a new liquidity trap occurred, but over a longer period of time. In the wake of the Bear Stearns bankruptcy in March 2008 and in spite of what on the surface appeared to be normal market conditions, the situation in securitised debt markets got steadily worse. Freddie Mac and Fannie Mae, which had underwritten more than USD 1 trillion in leveraged mortgage loans, were forced into heavy write-downs of asset values, as real-estate prices fell, default rates rose, and transaction volumes shrank. From August 2008 to March 2009, the phenomenon spread to the main banks, and liquidity dried up completely in some markets.
In 1987 as in 2008, liquidity gaps emerged for different reasons but led to major drawdowns.
What is the situation today?
Today, nine years after the latter crisis, central banks are in the midst of an across-the-board process of quantitative easing, cutting interest rates and buying up assets. More than USD 2.5 trillion was injected in addition in 2017 (see central bank balance sheet trends, opposite).
Unlike a traditional investor, central banks buy assets on the basis of a pre-set calendar and with no regard for prices. These transactions have psychological repercussions, by inspiring investor confidence. This over confidence about perceived stability in combination with a quest for yield also tends to lead to heavier debt burdens, which show up, for example, in the generalisation of share buybacks in the US.
In his 1986 work Stabilizing an Unstable Economy, the US economist Hyman Minksy discussed the idea that a perception of stability or comfort encourages investors to take excessive risks that could lead to phases of illiquidity.
Past crises have shown that drawdowns result from a lack of liquidity. This phenomenon could occur again, as extremely low volatilities reflect economic actors’ perception of stability. And yet, Minsky demonstrates how excessive confidence can produce illiquidity on some markets. Although it is hard to say when exactly that might occur, there seem to be some useful rules for managing a portfolio:
- Put risk at the centre of allocation decisions;
- Adjust portfolio risk on a daily basis (if necessary);
- Focus on diversifying exposure and keep some room to shift positions with asymmetric profiles.
More blog posts on liquidity and related topics
More posts by Fabien Benchetrit