Always Prepare for the 'Next' Minute
One of the most difficult financial concepts to grasp... The very essence of modern markets... This concept led to Long-Term Capital Management's collapse... It happens to stocks, too... Exactly why investors are vulnerable to enormous losses... Always prepare for the 'next' minute...
Of all the financial concepts I (Dan Ferris) have learned, 'liquidity' is one of the most difficult...
Part of the problem is that liquidity can mean different things...
For example, when you say that you have ample liquidity, it's another way of saying that you can handle a large, unforeseen expense. You could be talking about a home or car repair that insurance doesn't cover, a legal problem, or pretty much anything in between.
It's the same thing for a company with a large amount of cash on its balance sheet. The company has the means to cover any large, unforeseen expense or take advantage of any sudden opportunity that crops up.
In these instances, liquidity simply means having a large amount of cash on hand.
But that's not how I'll discuss the term today...
In this Digest, I'm talking about market liquidity.
That's the ability to buy or sell a stock, bond, option, or other financial instrument without swinging its price wildly. A liquid market barely seems to know you're there.
The opposite of market liquidity, of course, is market illiquidity...
When a market is illiquid, it doesn't trade frequently or in large enough amounts. That type of trading often causes the asset's price to jump around in a crazy way.
Microcap stocks are often illiquid, for example.
Sometimes, these stocks trade just a few thousand (or even just a few hundred) shares per day. Every now and then, you'll hear an investor complain that a particular stock "trades by appointment" – meaning that it's so illiquid it might take days to fill even the smallest order.
Market liquidity is obviously critical to avoid mass chaos...
Every day, millions of buyers and sellers trade thousands of stocks, bonds, futures, options, and other financial vehicles. And in many ways, they take liquidity for granted...
After all, many of these folks couldn't function as traders in their specific area without it. They would need to trade something else – or perhaps get a whole different career.
Deep liquidity is the very essence of modern markets...
Great investors know that. As billionaire trader Stanley Druckenmiller famously said...
It's liquidity that moves markets.
And it's not just well-known folks like Druckenmiller. Eric Cinnamond of asset-management firm Palm Valley Capital recently wrote the smartest thing I've ever read about liquidity...
... liquidity is downright fascinating. Investors try to measure it and make it quantifiable. We pretend we can define it, control it, and understand it. We can't. Liquidity is there or it isn't. It can be plentiful one minute and vanish the next. Liquidity can be a blessing or a curse – it is risk and opportunity.
Now, unlike Cinnamond, I believe we can define liquidity. But he's right when he says we can't control liquidity. And that gives the definition limited value.
We can't control liquidity because it's just other people's money. And you never know what they'll do with it.
Some folks might not be in the market at this exact minute. But then, they come barreling in the next minute.
On the flip side, some (or many) folks might be throwing their money at the next big thing today. But then, they throw in the towel and head for the hills tomorrow.
As Cinnamond wrote, liquidity is there or it isn't.
Liquidity underlies the concerns about 'mindless investing' that I've discussed a couple times recently...
As I pointed out in the September 1 Digest...
During the pandemic panic of March 2020 – one of the scariest market moments of anyone alive today – a Vanguard report found that only 1% of U.S. households abandoned equities completely.
Then, I wondered...
What would happen if 2% of households sold all their stocks? Or 5%? Or 10%?
Taking it a step further, the real question is...
What happens when the reliably deep market liquidity that everybody takes for granted every day is suddenly not there?
Now, you might think that's an academic question. You might feel like huge one-day losses across massive swaths of the market aren't likely.
I agree that these types of things don't happen all the time. But the point is they happen frequently enough to worry about. And in the worst-case scenario, you could get wiped out.
Throughout history, we haven't had many chances to see the answer. But it's never pretty. And it's not just a lack of liquidity. An unexpected flood of it can cause big problems, too...
In the late 1990s, liquidity caused big problems in the U.S. Treasury market – which dwarfs the stock market...
It played a huge role in the demise of Long-Term Capital Management ("LTCM").
The hedge fund was highly leveraged. And after market liquidity collapsed in some assets and soared in others, LTCM needed a $3.6 billion bailout from all the banks that lent it way too much money in the first place.
A story I heard back then illustrates what happens when liquidity suddenly flees markets. I'm paraphrasing because I first heard the story two decades ago. But here's the gist of it...
An LTCM trader called his broker to try to sell Russian bonds after Russia devalued the ruble and defaulted on some of its debt in August 1998. Bond prices are based on a par value of "100." (That usually works out to $1,000.) And here's how the exchange supposedly went...
Broker: OK, the price is 60.
Trader: 60?! I thought it was 90!
Broker: Now it's 50.
Trader: Hey, wait a minute...
Broker: Now it's 40.
The market for Russian bonds was in freefall for a simple reason...
Market liquidity had vanished.
Nobody wanted Russian bonds since the Russian government wasn't going to honor them. As any trader would tell you, there was "no bid."
Now, that's just an illustration of what happens when market liquidity disappears. It was only a part of what blew LTCM to high heaven...
A 2006 case study concluded that LTCM didn't get wiped out because of Russia devaluing the ruble and defaulting on its debt.
Rather, LTCM collapsed due to the resulting global 'flight to liquidity'...
In other words, traders exited less liquid fixed-income markets in favor of more liquid ones.
This case study proved that risk isn't just about a sudden absence of liquidity causing a problem. As I said before, a sudden abundance of liquidity can also cause a problem.
LTCM had $4 billion of net worth, but it had borrowed roughly $100 billion. And the hedge fund invested the bulk of that money in a specific trade...
It sold newly issued, highly liquid 30-year U.S. Treasury bonds while buying an equal amount of six-month-old, slightly less liquid 30-year U.S. Treasury bonds. Six months in, those 30-year bonds were essentially 29.5-year U.S. Treasury bonds.
LTCM made this trade to collect the "spread" between their two prices. And it relied on the fact that the two slightly different maturities of the same bond had different liquidity...
Lower liquidity made one bond slightly cheaper. That created a unique setup for the trade.
LTCM profited on the spread. And the trade worked great. It helped the hedge fund earn 40% annual returns until the day that Russia defaulted on its debt and devalued the ruble.
Since LTCM was using massive leverage, it needed the market to stay stable...
But that all changed with Russia's debt default and currency devaluation.
Capital all around the world exited riskier, less liquid fixed-income markets. And it headed for the largest, most liquid, and safest fixed-income markets – primarily U.S. Treasurys.
In other words, liquidity flooded into U.S. Treasurys – precisely because they were more liquid. That screwed up LTCM's trade badly. And it blew the hedge fund to high heaven.
LTCM's failure rippled throughout the world...
Investment firms like Salomon Brothers and Merrill Lynch had similar positions. Many large institutions were also LTCM clients – like Bear Stearns, which hastened LTCM's demise by demanding the return of its $500 million investment.
The Federal Reserve had to intervene and arrange the $3.6 billion bailout. That's because the central bank believed the global financial system was at risk.
And it was all due to the problem I've discussed today – market liquidity.
(The LTCM story has been told many times over the past 25 years. If you want to dig deeper, I recommend Roger Lowenstein's book, When Genius Failed: The Rise and Fall of Long-Term Capital Management. I also recommend my Stansberry Investor Hour interview with Jim Rickards, who was LTCM's lawyer and lead negotiator in the bailout.)
Of course, I get that most folks don't care about bonds – and certainly not Russian bonds...
But it happens to stocks, too. Throughout history, plenty of examples exist of liquidity falling out from under mega-cap stocks that everybody views as relatively safer than other stocks.
I warned folks about this problem in my presentation at our 2017 Stansberry Conference...
I told them that big, seemingly liquid stocks like Meta Platforms (META) – which still went by Facebook at the time – were vulnerable to big losses. Less than a year later (July 26, 2018), the stock fell 19% in one day. It lost an astonishing $119 billion of its market cap.
The stock fell from $217.50 per share at the close of trading on July 25 to $176.26 per share at the close of trading on July 26. Dropping that far that fast tells us one thing...
Nobody wanted to buy with the price between $217.50 and $176.26.
In other words, it means no market liquidity.
The same thing happened again on February 3, 2022...
Meta Platforms' stock fell 26% that day. An incredible $232 billion in market cap disappeared in the blink of an eye. It's still the biggest one-day market-cap loss in history.
Everybody thinks mega-cap stocks are inherently safer than their smaller counterparts...
And frankly, that's not a stupid way to think most of the time.
It's one reason why the benchmark S&P 500 Index and tech-heavy Nasdaq Composite Index did so well over the past decade or so. It comes down to the behavior of the masses...
People think the stock market is a safe place for their retirement money. So they buy a little bit more of the big indexes in their 401(k) accounts every time they get a paycheck.
To most folks, the S&P 500 is the stock market. So they buy it when they "buy stocks."
The trend of investors pouring money into 401(k) accounts was well underway when Meta Platforms suffered its big one-day losses in 2018 and 2022. But the constant bid under these types of mega-cap stocks from index investors failed to prevent those epic plunges.
The point I'm making might seem difficult to grasp. And yet, it's true...
By believing mega-cap stocks offer more safety than others, investors risk suffering enormous losses...
And if market liquidity dries up, those losses will be so sudden they'll be impossible to avoid.
It gets worse...
We're not talking about just a handful of stocks that everybody thinks is a no-brainer.
By definition, a mega-cap stock has a market value of at least $200 billion. And according to Bloomberg, 37 stocks currently fit that description.
That's roughly three dozen allegedly safe no-brainers that could deliver big, sudden losses. These stocks are just lurking out there, waiting to burn a hole in your retirement.
And of course, I believe you should worry the most about seven of these stocks...
We discussed the so-called "Magnificent Seven" of Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), Amazon (AMZN), Nvidia (NVDA), Meta Platforms, and Tesla (TSLA) two weeks ago. They're why the S&P 500 and Nasdaq are up about 20% and around 37%, respectively, this year.
Many folks once again view the most mega of the mega-cap stocks as an easy way to get rich quick. But almost nobody thinks owning these stocks comes with any risk that they could lose a lot just as fast.
Of course, if it can happen to Meta Platforms twice in five years, it can easily happen to the other six. In fact, it already has happened to at least four other Magnificent Seven stocks...
In addition to Meta Platforms, Apple is responsible for five of the top 10 one-day market-cap losses in history. And Microsoft, Tesla, and Amazon each own one spot on the list.
Keyboard cowboys, save your time. Don't tell me that the biggest mega-cap stocks would obviously be responsible for the biggest one-day market-cap losses. That's not the point...
The point is that highly liquid, seemingly safe mega-cap stocks can still get crushed on any given day. In other words, deep liquidity can be as fleeting as Cinnamond suggested.
I can't predict the future, but I suspect that the list of worst one-day market-cap losses will soon change. As I've pointed out time and again, these stocks are enormously expensive. They're trading for an average of well more than 50 times earnings today.
They're like the "Nifty Fifty" stocks of the late 1960s and early 1970s in more than just a flashy nickname. And many of those stocks lost 80% to 90% of their value by 1974.
You might not think the Magnificent Seven stocks will ever lose 80% to 90% of their value.
But are you willing to risk the bulk of your hard-earned retirement on it?
Remember, as Cinnamond said, we can't control liquidity. It's either there or it isn't. It can be a blessing or a curse. It can be plentiful one minute and vanish the next.
Make sure you're prepared for that "next" minute. You never know when it will come.
New 52-week highs (as of 11/30/23): Alamos Gold (AGI), CBOE Global Markets (CBOE), Cameco (CCJ), Cencora (COR), Salesforce (CRM), CyberArk Software (CYBR), Enstar (ESGR), Ingersoll Rand (IR), Iron Mountain (IRM), iShares U.S. Aerospace & Defense Fund (ITA), Cheniere Energy (LNG), Motorola Solutions (MSI), Palo Alto Networks (PANW), PulteGroup (PHM), Phillips 66 (PSX), Qualys (QLYS), Roper Technologies (ROP), iShares 0-3 Month Treasury Bond Fund (SGOV), Spotify Technology (SPOT), Stellantis (STLA), StoneCo (STNE), UnitedHealth (UNH), and Visa (V).
Today's mailbag includes more feedback on legendary investor Charlie Munger's death, which we covered in Wednesday's Digest and in yesterday's mailbag. Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.
"I haven't seen one mention of Charlie Munger's death on local or national TV news, nor in any of my daily news e-mails. Maybe the talking heads on the financial channels mentioned it, but I don't watch them.
"I wouldn't have even known about it if I hadn't read Whitney Tilson's daily e-mail and/or the Stansberry Digest. Shame on the mainstream media." – Stansberry Alliance member Greg F.
Good investing,
Dan Ferris
Eagle Point, Oregon
December 1, 2023