Liquidity is the scary absentee in stocks’ rebound

Earlier this week, Paul Britton chaired an informal meeting of fellow hedge fund managers and asked them why trading conditions have deteriorated so significantly lately. The lack of clear explanations unnerved him.

“We had a robust discussion but no one could give me a good answer,” admitted the founder of Capstone, a $5.6bn hedge fund. “But there’s an impairment in the US stock market’s liquidity. That severely worries me.”

Liquidity is jargon for how easy it is to trade in and out of financial markets. There are myriad ways of measuring it, but broadly speaking it is typically defined as the ability to easily buy or sell large chunks of debt, stocks or derivatives at or near the current prevailing price, and without moving that price significantly.

Wall Street has long complained that liquidity has deteriorated across markets in recent years, driven by regulatory and commercial pressures on investment banks to shutter their own trading desks and curtail the risks run by their “market-making” operations. Superfast high-frequency traders have stepped into the breach, but they have only a fraction of the capital of the big investment banks, and they quickly withdraw when markets turn turbulent, making prices more prone to jarring moves.

For instance, in December the so-called “depth” of the S&P 500 futures market, representing the range of available buyers and sellers, was even worse than it was at the peak of the financial crisis. As one major electronic trader puts it: “2018 was the first time it became very obvious that there are fewer people making markets these days . . . They’re fair-weather friends, and when the shit hits the fan they pull back.”

Worryingly, it seems that the market recovery of 2019 has not lead to a commensurate improvement in liquidity. Analysis by Goldman Sachs and JPMorgan indicates that the health of the US futures market has picked up from the December lows, but remains well below the post-crisis average. The limp improvement is both mysterious and concerning, and indicates that something fundamental might be changing.

Liquidity is a controversial topic, with many sceptics arguing that banks are merely moaning about regulations and using it as a convenient bogeyman as an excuse to attempt to loosen controls on their risk-taking. But while banks may be self-interested, there may still be a kernel of truth to their complaints: The market ecosystem has clearly evolved dramatically in recent years, and it seems to be changing the nature of market undulations.

Market volatility has simmered down again this year, with the widely followed Vix index, which measures the volatility implied by options prices, sagging back to a new low for the year of 13 this week. These are hardly the sub-10 readings of 2017, but are well below the long-term average. Yet there are mounting indications of a new market regime of stronger, longer rallies but more abrupt “sudden shocks” where prices abruptly careen lower before bouncing back.

As the Financial Times reported last month, Robert Hillman of Neuron Advisers, a quantitative investor, has estimated that since 2016 there have been four big market shocks — defined as one-day returns being five standard deviations away from the daily average return of the preceding month. That may seem modest, but we have to go back to the 1940s to find a three-year period where there have been this many sudden shake-ups.

Whatever its cause, the liquidity dearth could prove dangerous if it proves long-lasting. Last year’s stock market rout was primarily driven by hedge funds nursing losses on technology bets being forced to reel in their market exposure, but the severity of the damage it wrought was caused by atrophying liquidity, Mr Britton argues.

Calm stretches punctuated by sudden rises in volatility are problematic, as their speed and ferocity can discombobulate many investors — even for those that aim to profit from turbulence. Argentiere, a volatility-focused hedge fund started by a bunch of star JPMorgan traders led by Deepak Gulati, has decided to return some money to investors, Bloomberg reported this week, and Mr Britton says Capstone has ratcheted back its leverage.

The triggers for some of the recent sudden shocks — the Vix-linked funds that blew up in February 2018 and a hawkish Federal Reserve — are now at bay, and the roaring pace of corporate share buybacks have helped propel the stock market higher again.

Nonetheless, some of the underlying kindling for market infernos remain in place. The post-crisis bull run should remain intact as long as the global economy stays resilient and companies keep buying back their shares, but it could nonetheless become a bumpy ride.