What Happens When Liquidity Disappears?

by: Joseph Stuber

The recent mini flash crash precipitated by a bogus Tweet that an explosion had occurred at the White House should give both traders and investors pause and for obvious reasons. What happens when market liquidity dries up? Let me show you.


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Here's another perspective - this time on gold and it's even more dramatic.


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Here's one more stock showing the longer-term impact of that first capitulation sell-off. Those who expect a bounce back after a capitulation sell off are likely to be sorely disappointed.


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So there is the backdrop for the points I want to make - when liquidity dries up, markets go into free fall. Two of the three markets above were the darlings of investors - both large and small - last year. Today those investors are licking their wounds.

Tell me lies, tell me sweet little lies...

Those are the lyrics to the Fleetwood Mac song "Little Lies" that most of us recognize and maybe it should be the Fed's theme song. Actually the Fed hasn't lied to us about the impact of QE but they have allowed the lie to be disseminated to the public by pundits to the ultimate detriment of the investor.

What is stunning is the number of pundits that continue to speak in bullish terms as if there is simply nothing to worry about. The market has been anesthetized to negative data by the mistaken belief that the Fed can alter the direction of the economy or destroy the value of the dollar. Neither of these beliefs is true and it is never true.

The only thing the Fed can do is implement policy designed to alter sentiment. It is the private sector actors that must act in order to achieve the goals the Fed wants to achieve. The Fed can implement policy that they hope will influence the public's behavior but sometimes the public just doesn't respond as they are supposed too.

I want to mention a few points with regard to that statement and I promise to keep it short. By the way, what I am going to point out is so elementary that virtually all economists, analysts, business owners, CEOs, CFOs - well you get the point - they should all have a very solid grasp of these concepts. I learned the concept at 18 years of age in my Money and Banking class. Anyway, the point is that the Fed cannot create inflation. Let me explain.

Here is what is supposed to happen with aggressive monetary policy, i.e., QE. It is supposed to increase the available reserves in the private sector banking system. If the Fed lowers rates and increases the potential dollar amount of loans that can be made by the banks through liquidity injections, then the combination of these two things should motivate banks to lend and borrowers to borrow.

Each new loan increases M2 - literally out of thin air. After the borrower signs the documents, the bank makes two entries - a debit to the asset account (loans) and a credit to the liability account (deposits). That is all there is to it. The private sector bank just created brand new money that adds to the total and is available to the borrower to spend.

On the other hand when the Fed "prints" here is the bookkeeping entry:

  1. A credit to the private sector banks reserves account and a debit to the Fed's bond account. That is what happens at the Fed.
  2. The private sector bank's books end up with a credit to the bond account and a debit to the reserves account.

That is QE. That is all that happens. Show me please where M2 expanded with the Fed's print. Or better yet, tell me how a customer of the bank can spend the bank's cash and that is what QE does - it increases the bank's cash and nothing else and that doesn't drive GDP. Do you see my point - QE is not in and of itself in any way destructive to the value of the currency nor does it in any way impact economic growth. It just doesn't and that concept is so elementary that it is troublesome that so few seem to understand it. You just don't need a PhD in economics to get this point, so why is it that so few seem to get it?

My point is that most economic metrics are starting to deteriorate all around us as stocks march on their merry way to higher and higher levels. Investors are apparently oblivious to the fact that the Fed's policies are not growing the economy, destroying the dollar or creating inflation.

But wait a minute - maybe there are some who do understand the concept.

Well, maybe they don't understand the bookkeeping entries that well but at least they can see that the Fed's policy isn't working to change economic conditions. After all, we are seeing a number of indicators that show things just aren't getting better. And they need to get better if corporate profits are going to grow or even remain stable for that matter.

Here is the conundrum that large investors find themselves in today, and it goes a long way toward explaining why we are stuck at all-time highs and seemingly in a state of suspended animation. The truth is there are no buyers and those who already bought can't sell - at least the large investors - for fear of crashing the market.

Consider the bullish sentiment chart below:

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If the bears outnumber the bulls by a ratio of 4:1, then who do the bulls sell too? The answer - well you see the point I am sure - if nobody wants to buy what the bulls want to sell, the large bulls are stuck. Not many want to buy stocks at near all-time highs while the economy - on a global scale - is deteriorating to the degree we have seen in recent weeks.

Even a relatively small order can have disastrous consequences. Check out this chart on the Google (NASDAQ:GOOG) mini-crash on April 22nd:

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Here's how it was explained by the Wall Street Journal - Google Suffers Mini Flash Crash, Then Recovers:

At 9:37 this morning, in a flurry of trading, Google shares fell more than 3% in less than a second before reversing course.

Google fell from $796 to $775 in about 3/4 of a second, and then rebounded to $793 a second later, according to Eric Hunsader, who runs market-data analysis firm Nanex LLC. The drop involved 307 trades and 57,255 shares from 10 exchanges and dark pools, he said, while adding there were five orders placed for every trade executed.

57,255 shares is a pretty good size order for the average trader or investor but not for the institutional and fund investors. Here's a look at the top institutional investors holdings of Google:

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Just using JPMorgan (NYSE:JPM) as an example, a loss of 35% as we saw in Apple would result in a total dollar loss of approximately $1.75 billion for JPMorgan and that is just one stock in the banks portfolio. More important though is the size of JPMorgan's holdings of Google relative to the size of the flash crash trade. Can you imagine what would happen if JPMorgan decided they wanted to take profits on their Google stock? JPMorgan holds 111 times the number of shares that produced the 3% drop in Google.

How and why the market shrugs off bad news

Tuesday's S&P 500 was up 16.29 at 1578.79. The Dow was up 152.30 at 14,719.46. A pretty good day considering the dismal data we received starting with China's PMI which came in at 50.5 and down from 51.6 and followed by Germany - also down at 47.9 from 49.0.

If that wasn't enough, the U.S. PMI number came in at 52.0 and down from March's number of 54.3 - well below the consensus estimate of 54.2. To top off the morning's negative data, national chain store sales fell 2.8% in the first two weeks of April from March.

To put it in plain terms, the data was bad enough that a pre-open ramp was needed to prevent a lower open on the negative data that could end in a sharp sell off. How the market open was turned to the positive is simple enough - just pump money to the S&P 500 futures. Here is what happened in the pre-open period and how the positive open was orchestrated despite the negative data.

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That's the how and the why should be obvious - there is nothing but air under the market and a high volume sell-off could start a serious flash crash that could make the Google, Gold and Apple sell-offs appear timid by comparison. Coincidentally, we got a little taste of the high risk nature of the stock market with the bogus tweet on an explosion at the White House that caused the Dow to plunge 150 points in about 2 minutes which is also reflected on the S&P 500 mini futures chart above.

How we got here and why

To put it bluntly, the institutional investors and funds that hold large positions in U.S. equities are in a bit of a pickle, and believe me they know it. We are at close to all-time highs and yet almost everyone is bearish - a rather difficult situation for most to explain and a situation that creates a bit of a conundrum for these large scale investors.

This isn't a normal situation. Rarely are investors so bearish at market highs and at present the ratio of bears to bulls is 4:1. The conundrum is this - if the institutional and fund investors want to take profits because they see a lot of deteriorating economic metrics, they are not able to do so as there are no buyers.

We got here because of the Fed's self proclaimed 3rd mandate - the "wealth effect" - that Fed Chairman Bernanke has tried to create by manipulating the stock market back to all-time highs. You can argue that stocks are at all-time highs because of the record profits these companies have recorded in recent years and I won't disagree - at least to a point. The truth though is that sales and profits peaked early last year and yet stocks have continued to climb - not because of improving economic metrics but because the Fed has orchestrated the process.

I remember just a few months ago in December when Congress was tackling the issue of the "fiscal cliff" - a situation that should have caused the markets to sell-off. The tax hikes and spending cuts that Congress was tackling back then were certain to have a negative impact on GDP and everybody knew it. The Fed's solution was more QE - this time QE4.

Keep in mind, QE4 was a $45 billion liquidity injection program that followed the $40 billion program the Fed implemented 3 months earlier with QE3. No doubt the Fed believed the psychological effect of a new QE would keep the buy orders flowing and that is exactly what happened. The Fed made no attempt to tell us that their QE programs were doing absolutely nothing to impact the economy as almost all the liquidity injections were remaining at the Fed in the form of excess reserves and not moving into the economy.

They were quite content with the fact that at least their "wealth effect" agenda was working in that stock investors believed that dollar destruction and inflation were bound to occur and that meant a rapidly expanding economy at some point as inflation was a certainty. In other words, even if the Fed's policies weren't doing anything to stimulate the economy, at least the policies were driving stocks higher and maybe - just maybe - that would make investors feel good and start spending.

What now Mr. Bernanke?

I have said time and again that no attempt to corner a market ever ends up being a good thing and this time will be no different. The Fed's "wealth effect" agenda will prove to be one of the biggest monetary policy blunders in history.

There can be no doubt that we are suffering from the "law of diminishing returns." Consider the fact that we printed a flat GDP number in the last quarter of 2012; we are seeing top line corporate sales falling; the Euro zone is in recession and it is getting progressively worse; China is slowing down rapidly; monetary policy has not worked to induce inflation and money velocity is at decade's lows. The truth is we are experiencing rapidly deteriorating fundamentals at a time when the markets have undergone a Fed-induced rally that has pushed stocks into all-time high territory.

Just to reinforce the point, here are a few charts that establish that the Fed's policy has failed:

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Here's the big one - GDP:

Again, I ask -- what now Mr. Bernanke? You have managed to manipulate the stock market - if not the economy - back to and in fact above all-time highs. The problem is that the economy is faltering and there is no way for those who manage our funds to take profits without collapsing the market.

Concluding thoughts

This week we have had a little taste of just how thin the market is on the buy side at the present. The truth is there aren't any buyers - at least enough to absorb any significant amount of selling volume. So what do the institutional and fund investors do now?

Consider Google's 3% sell-off in less than a second on a 57,000 share order. That is not a big order in the grand scheme of things. Again, there are no buyers to absorb any significant selling volume today, but rest assured someone is going to try and sell into this void at some point and the risk-off sentiment that will grip the market will end up in a flash crash the likes of which we have never seen before.

We've had a taste of what can happen with Google, the tweet flash crash, Apple and Gold. These aren't anomalies as many think - they are a precursor of things to come and price matters. We are at all-time highs and we are there at a time when 80% of the trade is bearish and the global economy is contracting. That is a situation we have never seen before. It won't end well but it will end.

Disclosure: I am long FAZ, TZA, TECS, UVXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.