The Critical Role of Liquidity in Supporting Valuations

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I recently read an analogy in which the author compared the asset prices to an airplane flying at 50,000 feet, an abnormally high altitude. While our market plane cannot sustain such heights in the long run, there is little reason to suspect when or if it will fall from the sky.

Much is being written on the state of extreme equity and bond valuations. Surprisingly, there is little research focusing on what keeps valuations at such levels. Liquidity is our asset bubble's lift and worth closely examining to better assess the markets' potential flight path.

Market liquidity

In the investment world, liquidity refers to the ease and cost with which financial assets can be bought and sold.

For example, U.S. Treasury bills are highly liquid. They can change hands at a moment's notice usually at the prevailing market price.

Real estate is on the other side of the liquidity spectrum. Houses or land can take months or even years to sell. The seller often reduces the asking price and/or negotiates the price lower to affect the sale. Taxes, fees, inspections, and drawn-out settlement dates further de-liquify the process.

Liquidity applies to individual assets, as above, but can describe general market conditions as well.

Picturing liquidity

"The market is like a large movie theatre with a small door." Nassim Taleb

People typically enter a movie theater in a steady stream. Some arrive early, while others rush as the movie starts to find a seat. When leaving, there is an orderly exit, but even under normal circumstances, it takes a little longer as everyone departs at the same time. In market parlance, we can describe the regular entrance and exit of a movie as being generally liquid.

If there is a mass urgency to get out of the theater, exiting becomes disorderly or illiquid. In the 2008 financial crisis, liquidity in many securities was scarce. Think of it as being a crowded theater when a fire breaks out. Not only was it tough to get out, but the only way to exit, or sell assets, was if someone else was willing to enter.