By Gunjan Banerji
Stocks are flying high. Buying and selling them can be tougher
than it seems.
Liquidity -- how readily sellers can find buyers and buyers can
find sellers -- has been on the decline. That can mean higher costs
and more volatile prices. The problem can touch traders big and
small, from pension funds looking to hedge positions to retail
traders jumping in and out of individual stocks.
Liquidity is difficult to measure, but it is likely to be a
theme for investors in 2020.
"The number one client question in 2019 has been on liquidity,"
Goldman Sachs Group Inc. analysts wrote in a December note to
clients. The firm said earlier in the year that measures of
liquidity have shown "high predictive power" when estimating
volatility. The Federal Reserve also weighed in last year, listing
falling liquidity in its compendium of risks to the U.S. financial
system.
Liquidity in S&P 500 stock-index futures -- a crucial market
for hedging and making directional wagers -- remains weak after
dropping substantially during the late-2018 market swoon, according
to Goldman. Among single stocks, it hovered near some of its lowest
points of the decade in August, one of the latest periods of market
turmoil. And an unexpected spell of turbulence also hit money
markets in 2019, leading the Fed to flood the system with temporary
funding.
It can even be onerous to trade shares of individual companies
around the time of their earnings reports, according to a Goldman
analysis of stocks in the Russell 3000, a broad U.S. stock-market
gauge. Liquidity has dissipated on those days over the past four
quarters, falling below levels seen since 2008, according to the
bank, which measured how many shares are available to trade without
having a significant impact on prices.
"You've got to have a stronger stomach than you used to have,"
said Bill Smead, chief executive of Smead Capital Management, an
investment firm. "When there's no liquidity -- how low it can go
before it hits bottom -- it can shake you up. It's been a vicious
circle for years."
A corporate announcement these days can lead to a bigger stock
swing than it would have in the past, he said. Mr. Smead says that
means he can sometimes buy stocks for lower prices than he
expected. That was the case when he picked up shares of Occidental
Petroleum Corp., which were punished in 2019 during a fight with
activist investor Carl Icahn.
It is tough to identify a single cause for the slump in
liquidity, though a mammoth shift in investing has underpinned the
move.
Big banks are responsible for roughly half the activity they
were before the financial crisis, according to Bank of America
Corp., as high-speed traders and ETFs have picked up the slack.
Some analysts say the rise of passive investing, in which investors
try to mimic the market through index funds, exacerbates the
problem.
Meanwhile, trading firms providing continuous buy and sell price
quotes have fled some corners of the market, and firms serving as
middlemen between traders and central clearinghouses have backed
away from the business.
Traders say they navigate the issue in different ways, like
breaking up big trades into smaller, more manageable pieces to get
them done or simply charging more to take the other side of a
position.
Michael Beth, vice president of equity and derivative trading at
brokerage firm WallachBeth Capital, said he's had to get creative
when placing big orders. He was recently trying to trade shares of
casino operator Full House Resorts Inc., a stock he says has grown
increasingly difficult to move -- and had to seek out alternative
venues to traditional stock exchanges.
Other times, stock prices have fluctuated rapidly as he's tried
to complete a big trade for a client, he says, and he canceled the
rest of the order.
"It's gotten a little bit tougher," Mr. Beth said. "There's a
lot of demand the same way, so it ends up increasing your trading
costs."
Although liquidity has been a nagging concern among investors
for years, it recently came to the forefront. The Federal Reserve
warned in November of its risks in its Financial Stability Report,
an annual assessment on the resilience of the U.S. financial
system, saying liquidity had slipped in key markets like stock
futures and U.S. Treasurys at times in 2019.
The past year was also marked by unexpected market strains,
worrying some investors about other potential cracks in
financial-market plumbing. The Fed injected cash into money markets
in September for the first time in a decade after a sudden
shortfall of cash. The crunch led to spikes in the cost of
overnight loans using repurchase agreements, or repos, fanning
concerns about bond liquidity, too.
Widely traded products including one of the biggest
exchange-traded funds tracking the S&P 500, the SPDR S&P
500 ETF Trust, also appear to be affected, according to academic
research from Boyan Jovanovic of New York University and Albert
Menkveld of VU Amsterdam. The number of shares available to sell
near the best prices available has fallen over the past decade,
hitting a low in 2018, the research shows.
Some analysts have said the risks will grow more apparent in a
downturn, or if many investors attempt to sell similar positions at
once.
As stocks have risen over the past decade, many money managers
have piled into the same top performing stocks. The overlap in the
top 50 holdings between mutual funds and hedge funds recently
hovered at near-record levels.
"The liquidity crises seem to happen when everybody's trying to
sell the same security. It's like a rush for the doors," said
Savita Subramanian, head of U.S. equity and quantitative strategy
at Bank of America. "They're going to get a lot more volatility
than they're expecting."
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Write to Gunjan Banerji at Gunjan.Banerji@wsj.com
(END) Dow Jones Newswires
January 02, 2020 05:44 ET (10:44 GMT)
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