A False Sense of Liquidity?

 | Feb 02, 2012 | 2:32 PM EST
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When looking at the capital markets and their relationship to the economy there are many anecdotal, although empirically supported observations that can be made.

One of the counterintuitive ones is that stock market performance and economic activity are inversely correlated. Stock indices advance more during economic recessions and less during expansions. This is one of the rationales for the anecdote "don't fight the Fed." 

This is something that investors must always be mindful of, so that they do not get lulled into a false sense of security.

As equities increase in value investors should quietly be considering not only when they should sell, but who they will sell to. And that brings us to liquidity.

Stocks, bonds, commodities, currencies and their derivatives are assumed to be liquid investments and easily sold. 

Real estate, with the exception of REITs and other exchange traded vehicles, is not. Because of real estate illiquidity, the demand for it should always be more tempered than it is for the other asset classes. 

And yet bubbles and manias in real estate are possible as investors fail to account for this risk. 

Beyond that, Florida real-estate investors could contract to buy a property and then immediately sell that contract to another party in what was called an "assignment."

It was this perception of liquidity in the physical real estate market there that helped propel the rate of appreciation above almost anywhere else in the country. And yet, when the market began to correct, the buyers stopped buying the assignments almost instantly and simultaneously. Those holding property and contracts on properties recognized too late what was essentially a Ponzi scheme.

But most importantly, the majority of losses were not constrained to the speculators. Those have been borne by the long-term owners of real estate when values collapsed.

In the stock market there is also a belief that there is liquidity and because there is an exchange system in place there will always be a buyer to sell to. 

This is what is known as a confidence scheme and I don't mean that in a derogatory way. It's just a simple observation. The idea is that as long as investors believe there is always a willing buyer on the other side, their propensity to sell is dampened because there is no urgency.

Marketers, knowing about this, create urgency by providing deadlines like "sale ends in 10 days." 

The stock market does not provide such signals. A rising market can create an urgency to buy and a falling market the opposite, but these are after-the-fact signals.

Momentum traders look for both and that's fine. But following that as a long-term investor is a recipe for buy high, sell low. And it is reactive. 

When Fed Chairman Bernanke announced the extension of ZIRP for another 18 months it became a green light for speculators to buy. He was signaling that the economy would remain weak, warranting further stimulus and the mantra "don't fight the Fed" was given another push. 

It is prudent at this juncture for investors to consider what the limitations of Fed stimulus are and thus the limitations of speculators absolute trust in "don't fight the Fed."

Taken to its extreme, infinite monetary stimulus equates to infinite stock prices. It also means zero economic activity. In other words, investors are most rewarded if the economy collapses, which is obviously nonsensical.

Putting aside the inverse correlation of stock prices and economic activity, the real reason for monetary stimulus is to induce an increase in economic activity, not to drive up stocks. So far, three years into ZIRP, two rounds of QE and one operation twist have failed to provide it.

But the stock market is not reflecting any concern about this, so far. On the contrary, it is beginning to exhibit the same irrational exuberance of the NASD bubbles of the "new economy" and the Real Estate bubbles of the "real estate never goes down" mantra.  

The question for investors to consider now is about the relationship between the stock market and the economy. How long can the stock market continue rising with economic activity not following? What happens to the stock market if the economy does rebound?

Investors waiting for the answer to either question may find themselves in the same situation that owners of purchase contracts on Florida real estate did a few years ago.    

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