The Illiquidity Trap and the danger of too much intervention

There are two basic fundamentals that apply for all investors - from retail to professionals, from individuals to even nations. The first is to buy low and sell high and the second is consider return, risk and liquidity. The first seems obvious, but most investors in a bear market end up buying high and selling low. Why do you sell at a lower price? Because you run out of liquidity! Hence, the second fundamental is crucial to understanding how to survive in a bear market.

There are two types of investors - the value trader and the momentum trader. Warren Buffett is the classic value trader, carefully evaluating returns versus risks, accumulating at low prices when everyone is panicking and selling when he thinks the stock is fully priced. He is in a position to buy because he accumulated liquidity by selling high. He is actually trading in the opposite direction of the momentum trader, such as the retail investor who gets excited when the whole market gets hot and panics when the market gets nervous.

Since the information and skill of the retail investor is not as timely and strong as the institutional investor, many do not make that much money. Many retail speculators end up as long-term investors - they are forced to hold.

Ideally, the market should be stable if the momentum traders and value traders are in rough balance - the sellers equal the buyers. However, in emerging markets like China, where there are fewer institutional investors relative to the retail investors, momentum trading makes the market more volatile. The institutional investors also behave like momentum traders when the retail is moving and therefore push the market up and down like a yo-yo.

This is now the situation with the European insurers and Japanese banks, which hold substantial stocks in their portfolios. Mark-to-market accounting requires these financial institutions to recognise short-term losses in their profit-and-loss account, so that their capital adequacy is also affected. Hence, the more the market drops, the more these institutions may have to sell their shares, and this becomes a vicious circle.

Ironically, when long-term institutional investors should be net buyers in a bear market, their sales to meet their capital adequacy ratios make them net sellers. This is partly the reason why the Bank of Japan is contemplating buying stock portfolios from the Japanese banks.

We are in the danger globally of being in a liquidity trap. Even if many investors feel that the market is good value, they cannot buy because they are short of liquidity. Banks are no longer willing to lend readily to finance short-term needs, so companies and individuals sell to meet their cash flow needs, making the market more depressed.

This is the situation that the Western banking system is faced with. They are holding lots of toxic assets that no one can evaluate properly. The bid-ask spread (the difference between the offer price and the selling price) has widened considerably because no buyer is willing to pay a high price when they think they may end up with bad assets with no liquidity. The seller does not dare to lower the selling price because if it sells so low, it will incur large losses and may even become bankrupt. No trading means the market is illiquid.

But the wholesale banks have relied completely on the securitised asset market for their liquidity. So when the main source of liquidity dries up, they are forced to sell or reduce all their other assets, creating the reverse credit multiplier, which is bringing the real economy to a halt.

Market booms depend on liquidity - the more the banks are willing to lend, the more liquid the market. Therefore, momentum trading depends on strong liquidity feeding upon itself. However, the reversal of the liquidity cycle means that we are moving into a classic liquidity trap. In other words, central banks suddenly found themselves not only as liquidity lenders of last resort, but also buyers of last resort, including providing direct credit to corporate debt markets. The central bank can do this in a crisis, but if the central banker becomes the only lender in town and all banks are de facto nationalised, the free market has become central planning.

This is the basic difference between free market economists and Keynesians. Free market thinkers do not like government interference, because they feel that trading by governments distorts markets. But in a panic situation, when there are no buyers, the government may be the only buyer in sight, unless you open up your market to foreigners completely.

Hence the real philosophy of Keynes was to recognise that in a liquidity trap, only the government can stabilise confidence by intervening in the market. But if you intervene too much, you can also get inflation and further market inefficiencies.

In the next article, I shall look at the implications of global zero interest rate policy.