The Looming Liquidity Trap
The average person has no idea what liquidity in the stock market means. In the simplest sense, a liquid market is one in which buyers and sellers can be quickly matched. The opposite is true for an illiquid market, where there are usually more sellers than buyers and stock prices rapidly fall until buyers are found. Illiquid stock markets show up about every eight years and are most commonly associated with recessions. It’s during those times stock prices fall and investors are willing to sell at any price, which causes stock prices to plummet. At market peaks, liquidity is usually very high, but in our current market, we’re seeing the opposite scenario build – an illiquid market at the peak.
To give you an analogy of what liquidity is like, let’s say I dropped an aircraft carrier, perhaps one of the big fancy new ones, right in the middle of Kern River by Riverwalk Park. Aside from the fact that the aircraft carrier won’t fit, let’s still pretend I did that and challenged you with the task of turning the carrier around on its own power. You wouldn’t be able to budge it an inch. There’s not enough water, not enough space and not enough depth. That’s an example of an illiquid market.
If I take that same aircraft carrier and drop it in the middle of the Pacific Ocean and give you the same challenge, you’ll have no problem spinning the carrier any direction you want. The ocean is vast, it’s deep, it’s wide and there’s lots of room to maneuver. That’s a liquid market.
When markets peak there is usually a lot of liquidity. That happens because f the public, or retail investor, always buys at the top of every market. As the public gets excited that stock prices are going to rise ‘forever,’ they buy without any thought of how much they are paying. That frenzy of buying activity causes stock prices to shoot up, or go vertical, while at the same time the big money, or smart money, is actively selling. On a price chart, this event would show a huge spike in trading volume, which is known in the industry as a “blow-off” top. Where literally the top of the market is blown off like a geyser.
The smart money uses blow-off tops to exit their positions at the peak. From there, markets usually become illiquid as the smart money starts to bet on a market decline which leads to a rapid decline in stock prices. Once markets have fallen or exhausted all the sellers, because the public sells the most at the bottom, then the smart money steps in to buy. This happens during every market cycle. The smart money is so good at this that, unless you can get in sync with them, you’ll find yourself losing money about every eight years as the business cycle enters a recession.
Here we are, eight years into the third-longest expansion and soon to be the second longest business cycle in history. The Fed is tightening the money supply, which is a long-standing signal that the expansion is just about over. Normally at this point, the public should be buying stocks in droves, but they aren’t. The largest S&P 500 index fund, symbol SPY, years back-traded around $100 million shares a day. Last Christmas Eve it traded about $36.5 million shares on a day the markets close early. Today, SPY trades in the low $30 million shares per day. The mania normally associated with a blow-off top that signals the end of a Bull market run just isn’t there. So, what does all this mean?
What I believe is that the retail money has trapped the big money into this market, which is something that rarely happens. The big money relies on the retail investors to buy in droves at market tops in order to safely exit their positions without anyone noticing. But things didn’t go that way this time. This has forced the big money to find another route out because they know that when the Fed tightens, asset prices will fall. The big money wants out before that happens.
To push the markets higher, the big money has been forced to short volatility, which has the same effect of pushing stock prices higher. They have done this to create an opening so they can get out before it’s too late. To give you an analogy of what this scenario looks like, just like in the movies when the good characters are trying to get out of a sticky situation, the good characters often will prop up a rapidly closing door to escape before they are caught by the bad characters. In my opinion, this is exactly what we are seeing in markets today.
With one exception—the Fed, who was formerly on the good team when they were providing excess liquidity in the markets, has now become the bad team as they drain liquidity out of the system. In the movie analogy, the Fed is the door that is closing. Each day liquidity is slowly being drained and the smart money is trying to get out as fast as possible. The problem for them is that at market peaks the public normally provides that last bit of liquidity that the smart money needs to get out. This time, the public is completely tapped out. They are all in and have nothing left, which has left the smart money in a quandary.
To keep the door open, the smart money has entered record levels of short-volatility trades to prop the door open a little bit longer. The Fed has said the unwinding of their balance sheet will remain on autopilot, that is until February when we may or may not get a new Fed Chairman. On the other hand, by February, a significant amount of liquidity will be removed at a time when the public is facing higher prices. When you read reports that half of all American have less than $500 to handle an emergency and are living off their credit cards, it won’t take a big decline in the money supply to break the system.
When the buying stops, the world is going to be in for a shock at how fast our equity markets will unwind. Most people don’t understand that the Fed created all the liquidity that drove this market up over the past eight years. Nor do investors realize that stock prices have been rising as corporate executives borrow money to buy their stock back in order to pay themselves lavish bonuses. When all this happens, history will end up repeating, as it typically does. Stocks will fall. The public will be outraged. And the Fed will likely turn on the printing presses. For those with cash on the sidelines, this will be an opportunity of a lifetime.
Video Topic of the Week – Liquidity
A bit of expanded content on market liquidity.
Chart of the Week – McDonald’s
Many think McDonald’s stock is a great investment that could be held for years or even decades. Most investors today don’t bother to look at the balance sheet of what they are investing in. Once you review McDonald’s, you’ll quickly realize that people that have money in this market aren’t investors, they are speculators.
Portfolio Shield™ Update
The strategy continues to work as designed. Currently in the works is a fixed income version of Portfolio Shield. More on that when it’s ready!
Weekly Broad Market / Economy Commentary
Lately, I have been writing about the various sectors, but due to the time-consuming nature of this and that I often duplicate my comments in the video, going forward, I am going to limit what is written here. That may change, but right now with the retirement planning class in the second week, it’s just too much to do both.
Next week I am thinking about writing the main part of the weekly update on the various sectors and where I see opportunities and risk.
There’s been a continued about of excitement about tax cuts and how great that will be for stock prices. First off, tax cuts right now will not be bullish. I know what the news is saying, but this is a buy the rumor sell the fact situation if tax cuts are actually passed.
Due to the very short amount of time left in the year, it’s very unlikely that there will be any substantial tax reform if any at all. The reason it is bearish is because the Fed is tightening, or pretending to tighten. I say that because there’s not much evidence other than what they claim to be doing.
Tax cuts put more money into people’s pockets, which increases the money supply. With the Fed tightening, a tax cut means they will likely increase the tightening by raising rates faster.
Tax cuts are bullish, but only during a recession. In the late stages of an expansion when the Fed is worried about a spike in inflation due to all the money printing, tax cuts are bearish.
At this point the stock market is so far removed from reality and fundamentals, everyone who claims to be an investor is a momentum investor. If you don’t believe me, be sure to watch the video or download the chart pack to look at the fundamentals of McDonald’s. They aren’t anywhere as good as you might think.