EC The Lifeline Of Markets – Liquidity Defined

We recently read an analogy in which the author compares the current state of asset prices to an airplane flying at 50,000 feet. Unfortunately, we cannot find the article and provide a link. The gist is market valuations are flying at an abnormally high altitude. While our market plane cannot sustain such heights in the long run, there is little reason to suspect it will fall from the sky either.

Many investors are writing on the current state of extreme equity and bond valuations. Surprisingly, there is little research focusing on what keeps valuations at such levels. Liquidity is our asset bubble’s lift and worth closely examining to better assess the markets’ potential flight path.

Market Liquidity

In the investment world, liquidity refers to the ease and cost with which financial assets can be bought and sold.

For example, U.S. Treasury bills are highly liquid. They can change hands at a moment’s notice and usually at the prevailing market price.

Real estate is on the other side of the liquidity spectrum. Houses or land, for instance, can take months or even years to sell. The seller often reduces the asking price and/or negotiates the price lower to affect the sale. Taxes, fees, inspections, and drawn-out settlement dates further de-liquify the process.

The term liquidity applies to individual assets, as above, but can describe general market conditions as well.

Picturing Liquidity

The market is like a large movie theatre with a small door.” Nassim Taleb

People typically enter a movie theater in a steady stream. Some arrive early, while others rush as the movie starts to find a seat. When leaving, there is an orderly exit, but it takes a little longer as everyone departs at the same time. In market parlance, we can describe the regular entrance and exit of a movie as being generally liquid.

If there is a mass urgency to get out of the theater, exiting becomes disorderly or illiquid. In the 2008 financial crisis, liquidity in many securities was scarce. Think of it as being a crowded theater when a fire breaks out. Not only was it tough to get out, but the only way to exit, or sell assets, was if someone else was willing to enter.


Liquidity Is Least Plentiful When You Need It Most

When prices rise steadily and predictably over months or years, and the ability to buy or sell an investment is both transparent and efficient, the importance of liquidity is usually taken for granted and ignored. The prices we observe on our monitors are the prices at which we can sell.

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William K. 2 months ago Member's comment

I would not be"predicting fire." More like a collapse, without even a chance to get out of one's seat.

Indeed the challenge of selling is that there must be buyers. That is often the problem found when the rise has become flat and suddenly the rise that would not stop DOES STOP! The pain part about getting rich quick by selling stocks that have risen o much in price is that not only are there no buyers at that price any more, there are many thers wanting to sell. So hope that the shares have not been bought with borrowed money and a loan now come due.

Cynthia Decker 2 months ago Member's comment

Great article, thanks.