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Written by Thomas M. Geier, CPA, CFP®, PFS

Successful investing requires periodic evaluation of risks. Over the years, most investment themes tend to play out in cycles, and the threats to profitable outcomes will rise and diminish accordingly. For example, rates on 10 year US Treasury Notes (a benchmark for bonds) is near the lowest it has been over the last 60 years, a cyclical low for sure.  Therefore, the risk to bond investors of a significant increase in rates that will lower the value of their bond holdings is abnormally high. A smart investor will recognize this risk and adjust their bond expectations accordingly.

10 year treasury constant maturity rate

One risk to the markets that has raised its head recently is lack of liquidity. In fact, within the past few months, most of the major investment news outfits have written about this concern. The Wall Street Journal ran an article on May 20, 2015: Why Liquidity-Starved Markets Fear the Worst.

The Financial Times also expounded with Liquidity Pitfalls Threaten Parched Markets, published on June 18, 2015.

Even the International Monetary Fund (IMF), in their April 2015 Global Financial Stability Report, made the statement that, “markets could be increasingly susceptible to episodes in which liquidity suddenly vanishes and volatility spikes.”

Liquidity in markets means that it is fairly easy for a seller to find a buyer and a buyer to find a seller. Also, a reasonable price at which to buy or sell can be obtained. Assets that can readily be bought or sold, or converted to cash, are considered liquid assets. When liquidity is absent, vast swings in the price of the asset occur. For example, market crashes occur when there are too many sellers and no buyers. It takes a lower and lower price in order to convince someone to buy the stock that you would like to dump.

These articles spell out some of the causes of the feared lack of liquidity. One embedded cause is the proliferation of regulation after the 2008 financial crisis. Many curbs were put on banks, brokers, and other financial concerns which had always acted in the past as “market makers” or buyers of last resort. These entities acted as middlemen to help buyers and sellers find each other and transact business. Regulations, such as Dodd-Frank, now restrict the ability of these concerns to act in this capacity. The intent was admirable but may have had unintended consequences.

Liquidity concerns in the bond market are due to the Quantitative Easing policies of the major central banks. As these banks have absorbed the largest percentage of sovereign debt, these bonds are no longer available in the open market. For example, the US Federal Reserve now holds over $4.5 trillion in various bonds on its balance sheet. A shortage of supply of these bonds means bigger swings in price.

federal reserve banks total assets

Another factor in low liquidity is the buy up by corporations of their own stock. According to Bloomberg, S&P 500 corporations spent about $600 billion on stock repurchases in 2014. As these companies retire stock, less is available as supply in the open market. This tends to drive up the price. True, some companies need to buyback their shares to offset options given to employees, but this is not significant compared to the overall level.

High Frequency Trading now accounts for over 50% of the cash trades placed on the exchanges each day. Instead of people making decisions in tight or unsettled market environments, computer algorithms chase trends that the programs discover and may exacerbate swings. The “flash crash” of 2010 is attributed in large part to HFT.

The growing use of Exchange Traded Funds also may affect degrees of market moves. EFT’s are baskets of funds. In a bull market (rising market) EFT’s tend to help support prices. For example, if a company issues good earnings, shares are sought not only by buyers of the individual shares of the company, but also buyers of the ETF basket. If a company issues bad earning, the ETF may act as a support mechanism as sellers sell the individual shares of the disappointing company, but buyers who are buying the ETF are buying it as part of the basket. The concern is for a bear market (down market).  Worries are that sellers will be selling not only their individual holdings for cash, but their baskets of stocks as well. This could add more pressure to the downside.

Fortunately, with all of the discussion about potential liquidity problems in the press, regulators are examining ways to mitigate the damage. However, solutions are not readily visible right now and we really do not know what to expect.

In the meantime, investors must prepare for potential significant swings in the market. Examine your cash needs over the next few years. If you need to sell, make sure your timing is such that buyers of your holdings are available at a price you can accept. Also, think about the level of price volatility you can tolerate. If you can’t sleep at night if your portfolio hits a certain lower level, take action now to lighten up a bit.

At Geier Asset Mangement, we can help you evaluate your risk tolerance and align your portfolio to your goals and time horizon.  We do not know when, if, or how liquidity issues may cause significant, actual market swings, but we can work to minimize the downside damage to you and your portfolio and maximize the opportunities for profit.

 

© Geier Asset Management, Inc. June 2015.  Thomas M. Geier is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor.  The above blog reflects the opinions of Mr. Geier and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance. The firm makes no warranties or representations of any kind relating to the accuracy or timeliness of the information provided.