Saturday, August 24, 2019

Liquidity Is Often The First Casualty In A Financial Crisis

During Market Carnage Liquidity Takes Flight!
For years investors have been rather complacent to the risk they faced and because of this, leverage has slowly built up within the system. It is important to internalize in your mind that buying the dip is not a trading strategy carved in stone. There is a reason we have been warned; "do not to try to catch a falling knife."

Sadly, banks have a way of failing us when we need them most and that is a big part of why liquidity is generally the first casualty in a financial crisis. A huge part of the problem is rooted in the economic tool known as leverage. The same massive gains leverage brings, also showers us with huge losses that rapidly paralyze both individuals and financial institutions. When volatility hits the markets any person or group with less than stellar credit are likely to find they are unable to borrow new money.

Often even those with good credit are forced to watch as even existing credit-lines are cut. The bottom-line is banks do not like to loan money to those that need it but prefer to line the pockets of those who dwell in their inner circle. Many of the credit-lines that existed prior to 2008 have gone the way of the dinosaurs with banks claiming new government regulations are to blame for the way they do business today. Much of this is hidden away in that pesky small print that exists is all the paperwork we sign when dealing with these institutions. This is especially clear in the commercial real estate market. CEO Chris Maher of New Jersey’s Ocean First Bank has already pulled back on refinancing transactions that let customers cash out on their debt, and has started reducing exposure to industrial loans. He told Reuters.

“In a downturn, industrial property is extremely illiquid,” he said. “If you don’t want it and it’s not needed it could be almost valueless.”

It is the slow movers and common folks that will suffer the brunt of a falling market. Phone lines get jammed and computer access backs up or becomes unavailable as "at market orders" flood the system. With this in mind, we should not rule out the possibility that much of the "smart money" has already exited the stock market in recent months or hedged in a way to minimize potential losses. Another problem for the bulls is that many shorts got out of the market long ago and today many traders are playing on borrowed money. This means the margin calls will be fierce. Market uncertainty combined with the desire to protect capital tends to create a "circle the wagons" mentality. The lack of liquidity it fosters will be particularly hard on high yielding and smaller markets with narrow appeal.
Liquidity Falls Off The Chart In A Financial Crisis
Uncertainty rules during a financial crisis and when liquidity drys up cash rapidly becomes king. Anyone doing a great deal of negotiating knows the one-word people wanting to reach an agreement don't want to hear is "IF"! This is why I will never call the holder of cash stupid unless it is during a long period of massive inflation.

We should remember how well banks fare if assets retrench will depend a great deal on the collateral they have glommed onto prior to the onset of the difficulties. Falling oil prices are already putting pressure on a slew of oil patch loans and bonds. It is also important to remember historically banks have been poor managers of any tangible assets that require day to day care. One thing banks do not need is a slew of properties defaulting on loans and coming under their control.

In a recent article, I questioned whether we have entered the period that may someday be referred to as "The Great Reset" where values might be shaken to their core. If so, the ramifications are that assets such as stocks could take it hard on the chin. When adjusted for inflation, the case could be made that stocks may not recover for decades. The market surge since 2008 has reinforced the myth that stocks move upward and always recover if you ride out market tantrums, however, this is not true. All those owning shares of GE, GM, and a slew of other companies caught up in the last crisis will confirm that holding on to an investment does not always make you whole. When markets cross into bear-market territory and retreat from their peak market psychology begins to change and "worry" becomes the word of the day.

During the December 2018 market pullback, the five FAANG stocks. Facebook, Amazon, Apple, Netflix, and Google/Alphabet together accounting for more than two-thirds of the Nasdaq-100's loss. When such high-flyers that are always being hyped in the news get whacked traders take notice. With liquidity on the wane and traders rather nervous this might be a bad time to buy the latest dip. Remember the market has climbed a long way in the last ten years without a major correction. While the idea of buying stocks when the market is out of favor sounds great pulling the trigger is difficult in an unstable market which causes many investors to alter their plans. Be careful out there, and remember capital preservation is job one!
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