Keynes on liquidity and markets

“Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.” 

-Keynes 

What will be the biggest risk for 2015?   It will be liquidity. There will be more one-sided risks based on any significant changes in beliefs, but these shifts will be heightened because liquidity will be missing.  There will not be any dealers standing on the other side of the market. So should investors  pay a premium just to have liquidity? The answer is no, but shifting to less liquid markets is not going to be a solution either. Investors just have to work under the assumption that liquidity will not be present at the most critical times and the Fed may not have the tools to solve the problem. 

I am in the liquid alternative space, so do I have a fetish for liquidity? I just know that liquidity will be scarce when you need it so you better plan for every exit. That does not mean that you have to have stop-losses on every trade. Markets can easily blow through stops so it can provide a false sense of security. The only ways to really protect against a liquidity crisis is through diversification and limiting leverage. Diversification is simple - never place too much in any trade and assume that correlations will go up in a crisis. Leverage is also straight-forward - do not use too much leverage no matter what is the return to risk. 

Everyone cannot have liquidity, so it is critical to monitor markets for reversals. If trends change, the response has to be swift and without hesitation. Cut or reverse positions. Use the liquidity first because there may not be much behind it in the short-run. 

No dealer profits and the potential for a liquidity crisis

Major bank dealers are seeing continued erosion of profits since the Great Financial Crisis. There is no more proprietary trading with the Dodd-Frank rules. Volatility is down and trading volumes have declined. It is just hard to hit ROE targets in traditional, fixed income, commodity and currency trading in the current environment. 

Many investors will argue that this is a good thing. Banks have been making money from clients for decades so let them suffer. Nothing like seeing Wall Street titans taken down a notch. But, if you are interested in systemic risk, you want to think through the implications from this profit decline.

Dealers make markets in strategic asset classes. The bond market is the place for safety in a crisis. Currencies are the biggest trading markets in the world. Commodities are a critical input to the real economy. The trades that can go through these markets can be very large and they need immediate liquidity. If there are no dealers, and make no mistake, banks are the only intermediaries with the balance sheets to provide liquidity, there will be limited liquidity in these markets. Futures traders, HFT traders, and hedge fund speculators do not have the capital to provide liquidity in the short-run. They do not have the relationships that will allow them to take trading risks that will be paid back in other ways. 

If banks start to streamline operations, cut head count, and reduce trading capital, there will be a liquidity impact and this will lead to true systemic risk. This market readjustment is happening now. A liquidity crisis is exactly what the Fed wants to avoid, yet the system may have gotten riskier.

Peter Lynch on anticipating corrections

Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.

- Peter Lynch 

Taker risks, just make sure that the risk are prudent. The correction is the exception not the norm. Realize that markets will correct, but the most likely scenario is that they will maintain the status quo. If a market is trending up, it will likely continue to move in that direction. It will change, but trends will last longer than expected. A focus on the current market environment is better than a forecast on the reversal that is less likely to occur. Peter Lynch was not a trend-follower but it is unlikely he wold fight the market direction under the assumption there will be a change.

One of the key advantages of trend-followers is their willingness to stay in the current market environment and not in the environment of "what if". This could be one of the key distinctions between systematic and discretionary traders.

Nevertheless, every trend-follower has an exit strategy and realizes there is a time to walk away. The exit is usually based on the a reversal of price not based on a fundamental forecasts but on market behavior. There is a willingness to give up some existing profits to stay in a trend until there is an actual sign of a reversal.

There is a higher likelihood of an equity market correction. The case can be made through looking at valuation, length of cycle, and some fundamentals, but if price behavior is telling us otherwise, the disciplined money will stay with the current trend.

Explaining and predicting - the economic difference

Jon Elster's words:

Sometimes we can explain without being able to predict, and sometimes predict without being able to explain. (Nuts and Bolts for the Social Sciences, p8)

This is one of the most important lessons for investors when they are reading Wall Street research. Most of what is presented is explanation of what is going on the market. There analysis is presenting of facts and an explanation of what those facts may mean relative to past information or other facts. However explaining is not telling stories of correlation as causality. Often researchers look at correlation as causality and thus an "explanation".This is where the trouble with analysts begin. This is not prediction and it is not good analysis.

Providing facts in a structured manner is useful; however, it is often not colorful and will not earn an analyst the big bucks. The status from making forecasts is why analysts get into the prediction game but it is at the expense of investors because most analysts get it wrong. 

There are analysts who are good at explaining, but predicting is a whole different story. Explainers are not always good forecasters. Investors should never confuse the two. Reading research is useful to give context but context is not always the road predictive power. 

The confusion between explaining and predicting can be eliminated through the use of models. The quality of a model is not based on the glibness of a speaker or their style of writing. The success of a model is based on whether it works. It is measurable prediction.