The Incredibly Shrinking Market Liquidity, Or The Upcoming Black Swan Of Black Swans

"Anyone who is doing anything sensible right now is either losing money or is out of the market entirely." These are the words of a quant trader, who is seeing something scary in the capital markets. Scary enough to merit a warning that we could be on the verge of another October 87, August 2007, or January 2008.

Let's back up. I recently posted a chart which tracks equity market neutral strategies: in essence a cross section of quant funds for which there is public performance tracking. The chart is presented below.

There is not much publicly available data to follow what goes on in the mystery shrouded quant world. However, another chart that tracks the market neutral performance is the HSKAX, or the Highbridge Statistical Market Neutral Fund, presented below. As one can see we have crossed into major statistically deviant territory, likely approaching a level that is 6 standard deviation away from the recent norms.

What do these charts tell us? In essence, that there is a high likelihood of substantial market dislocations based on previous comparable situations. More on this in a second.

Why quant funds? Or rather, what is so special about quant funds? The proper way to approach the question is to think of the market as an ecosystem of liquidity providers, who, based on the frequency of their trades, generate a cushioning to the open market trading mechanism. It is a fact that the vast majority of transactions in the market are not customer driven buy/sell orders, but are in fact high frequency, small block trades that constantly cross between a select few of these same quant funds and program traders.

This post at zerohedge is referenced and explained by Karl Denninger, at Do Not Be Stupid:

We're almost to Tax Day.
And the "New Bull Market" callers are out in force.
Just as they were last year.
Let's look at reality here folks:

There is a major liquidity disruption under way right now in the markets. Zerohedge put forward a rather esoteric diagram of this; I don't need one, as it is trivial to observe this in the form of real-time time-and-sales data. Volume has been thin and declining while machine-driven ("quant") trading as a percentage of total volume has been flying higher.
There have been a series of overnight 'gap higher' moves in sequence followed by days that fail to follow through strongly (that is, larger than the overnight gaps.) This is abnormal and points to "at the margin" price changes. The key point here is that this is unsupportable over the longer term as the actual base of equity trading; "long-term" owners such as individuals and pension funds are NOT following through during market hours and those holders are not trading /ES futures overnight on Globex!

The effect of (1) and (2) is what is known in the investing marketplace as "distribution" - that is, you, the retail bag-holder, wind up with the shares at the end of the day, and the institutional and quant-driven "fast money" departs with your cash. When they stop their high-frequency "pass across the table" game, and they will, you find yourself with some very expensive shares as the floor disappears.
Distribution marks tops, usually very significant ones.
A month or so back I was warning of a potential credit-market dislocation and imminent collapse in the stock market. It was "saved" to a large degree by these quants and other "high frequency" guys, all of whom have a vested interest in seeing that happen (think of the name of any big investment bank; there you will find one of those parties.)
But their firepower and willingness to play this role is not unlimited. Buying and selling between these firms is a nice way to book some profits, but these folks understand the rubber-band problem when markets get stretched, and exactly when their liquidity disappears is a matter of time, not supposition.
The imbalance that is presented here has led to the recent rally, but do not be deceived - this is not a new bull market.
Bull markets don't feature this sort of distorted move. Rather, they are measured, reasonable advances with most of the buying being real and taking place during market hours.
If you got "stuck" in positions either last fall or over the winter months, you've been given a gift. Exactly how far this gift will extend your ability to recover some part of your losses is unknown, but the fact that so long as this pattern persists one must keep a wary finger on the "sell" button is not at issue.
Ignore this warning at your peril.

Much of it was made out of air in the first place. Something without real value (artificially low rate credit) was chasing overpriced goods. Overpriced, as the credit offered with terms above the ability to pay them back generated more demand than market forces should have dictated.

When someone is offering a home loan that’s under water at the onset, people overbuy, figuring the value of the home will go up & a more conventional loan can be taken out down the road. You have a lot of people make that gamble, it inflates the market, people willing to bid higher than they otherwise would.

When the true market value tries to assert itself, due to defaults, wild credit & terms dry up. Then you have fewer buyers chasing the goods, which deflates the value to a more realistic market value, dictated by a greater ratio of *qualified* buyers.

Housing was only one sector where that sort of thing was going on. Many of the instruments that underpinned the activity were leveraged, which inserted even more air.

Appreciate you posting this, I was trading the finnies in pre-market for most of the month, but I was stunned to the point I pulled out of the market by 9AM on Thursday. The WFC execs on the TV were outright scumbags on parade.

In our post, in the comments section, I found another good blog post by the renowned and reviled Martin Armstrong:

http://www.contrahour.com/contrahour/2009/03/martin-armstrong-is-it-time-to-turn-out-the-lights.html#comments

Reading that sutff reminds me that the bulls and the bears are chasing concepts and strategies not fully understood in a market with this level of volatility. With that in mind it’s hard to see how some of TD’s assertions are justified.

There’s always a certain amount of fluidity in “value”, generally tied to how much someone is willing to pay for it. Your boat is a good example of that.

Now that you have the $4500 profit in hand, what you do with it, where you put it will influence whether or not you retain it, gain more from it or lose some or all of it.

Still, whenever dealing with hard goods, some of the value is related to producing them. A market that has been flooded can & will at times act counter to this rule of thumb if inventories get too high. A producer may sell off at a loss to stay afloat, but that kind of thing generally doesn’t last & depends a lot on how much distortion there is in a market.

A distortion can be something like government subsidies high enough to make additional production viable despite rising inventories. Beyond propping up a dying industry, like buggy whip manufacturers to keep jobs, other considerations may come into play.

Take an industry the might be needed for building up national defense if the nation was attacked, like making steel. Currently, we import a lot of the steel we use domestically, due in a large part to environmental regulations. The industry was given some trade protections, as it’s not the kind of industry you can build from scratch overnight & begin output the next day.

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