January 2009 Market Update - The importance of liquidity

The above economic problems are not new. We have experienced many recessions and stock market falls since the 1930s, and the reactions have not been as violent. So what was different this time? Part of the problem has been the distinct lack of liquidity in most asset markets. To understand what ‘liquidity’ means we only have to look at our domestic residential property market. The reluctance of domestic banks to lend to individuals following the demise of Northern Rock has caused house prices to fall and there are a lack of buyers to take advantage of these falls; either because they fear further falls or they cannot obtain the finance to do so. If you are a forced seller of a property, perhaps because you are unable to meet your mortgage payments, then the only thing you can do is mark down the price of your property until a buyer is found. This price may not be the ‘real’ price for the property, but as you are forced to sell you have to take what price is given to you, regardless of the property’s worth. Now, if we replace the individual with a hedge fund for example, we can begin to see why, perhaps, some assets have been sold off regardless of their real worth. Hedge funds have historically borrowed heavily to invest in stock and other markets, as we as individuals have in property. However, their problem is not that they can’t meet their interest payments, but it is because either: regardless of worth. Indeed, it might be they have been forced to sell the best quality assets, since those are the only ones there are buyers for. In these scenarios the fundamentals of investment are being ignored, since it is the drive to raise cash that it is at the forefront. This is why the asset price movements seen have been severe, because the falls have been exacerbated by those, such as hedge funds, who borrowed to invest.

1. Banks want their money back, forcing them to sell assets

2. A significant proportion of money they have borrowed has been lost, forcing them to sell assets

3. Volatility has increased significantly, causing the banks to reduce the amount of money they will lend in a corresponding fashion. Volatility also increases the deposits required to trade on margin. Whereas a year or so ago a hedge fund may only have had to deposit 10% of a trades value with an exchange, now that amount may be 50% or more. If a hedge fund had an investment in 1 million pounds worth of stock 12 months ago, they would have had to deposit 100 thousand pounds to cover losses on the trade. Now they may be required to deposit 500 thousand pounds, If they do not have the extra 400 thousand pounds they are forced to sell the investment.

4. Redemption of hedge funds by investors is estimated to be £10s of billions, forcing hedge funds to sell.

In all of the above scenarios, nothing has been going right for hedge funds and they have been forced to sell assets

The outcome is quite important for us as investors, since the huge numbers of forced sellers may well present opportunities. Some share prices are correctly reflecting the fundamentals but others may be in the ‘sold regardless of worth’ category. There can only be a finite number of sellers after all and we have high levels of cash in the funds that we manage which may enable us to take advantage of any ‘oversold’ assets.