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While Liquidity Improved, Wealth Still Eroded

Nearly all financial markets finished lower in February, the one exception being the CIX (index of five largest cryptocurrency pairs):

7-10 Year Treasury Bonds

-4.1%

Investment Grade Corporate Bonds

-4.3%

S&P500 US Stock Index

-1.6%

WTI Crude Oil

-2.2%

Copper (COMEX front month futures contract)

-3.5%

Gold

-5.4%

Silver

-12.4%

Crypto Index (CIX)

+1.4%


All markets are, to some extent, liquidity driven. Liquidity is practically equivalent to the key phrase the Chairman of the Federal Reserve uses in every press conference he gives: "financial conditions".

Quick Non-legal Disclaimer: This information is for readers who manage their own investments as well as those who entrust that role to a financial advisor. In my view, most people should have a financial advisor. Just as I do not have the expertise to repair my own engine or perform surgery on my own organs, most people do not have the knowledge or time to manage their own nest egg in an intelligent way. This content will help you to ask your advisor the right questions. Professionals in this sector should always have a thesis on whether assets are cheap or expensive, and should be equipped to get you greater diversification than the two most heavily invested asset classes: broad market stock indices and bonds. Like a doctor, they should also be abreast of the latest research in the field.

Liquidity is a financial institution's ability to match its cash outflows with cash inflows in time. When an FI agrees to make a three month loan for 100 million dollars starting in two days, it isn't going to use money that is already sitting in a bank account somewhere and send the money when that day comes. While most people think of banks as lenders, not borrowers, the vast majority of lending institutions actually lend borrowed money.

The FI will go into the money market now and arrange to borrow the 100 million dollars, often for a shorter term than three months, perhaps a week. The FI matches the asset (lending for three months) with a liability (borrowing for a week). The essence of liquidity is how easy it is to make arrangements like these.

The household makes liquidity decisions in a similar way, just without the borrowing component. We do not hold enough money on deposit at the bank to pay all of our future car payments or mortgage payments. Most of us expect the income from a stable job. If that job goes away, we become "Illiquid" in financial terms. Illiquid means that even if our total assets are greater than our total liabilities, which is called being "Solvent", we are unable to service debt, contractual and biological obligations (like eating). Illiquidity means risk of default for both households and businesses.

For stocks, bond, and other asset prices to rise, there has to be trading volume to support them. Much of the trading is done with borrowed money, therefore to support trading volume, there has to be liquidity. When liquidity is low, asset prices fall.

Despite the negative monthly returns listed above, the S&P 500 index is up about 9.6 percent from the lows of October 2022, and talk of rebound is surfacing in the media sphere. CBS is reassuring everyone that "Investment Experts" say it's best to keep pumping a slice of your paycheck into the stock and bond funds in your 401K with each passing month.

The largest investment vehicles for US stocks and bonds are both down 16 percent from their late 2021 all time highs. What has liquidity been like during this 15 month correction? The Federal Reserve Bank of Chicago keeps a National Financial Conditions Index, updated every week. By this measure, liquidity is actually still in "positive" territory relative to historical averages.

Chicago Fed National Financial Conditions Index. Red lines from left to right: Pre Great Financial Crisis July 2007, European Debt Crisis July 2011, Pandemic Panic February 2020. US equity losses were small and short lived during the Eurozone Debt Crisis. The above chart is inverted because the Chicago Fed indicates loose financial conditions with figures below zero and tight financial conditions with figures above zero, and I think it's more intuitive the other way around.

The index bottomed at a level of 0.11 in October, coinciding with the most recent trough in all markets. However, it improved for the next three months, including February, even as we saw the declines listed above. If "correction" has meant a 16 percent drop in the average 401K when liquidity is still relatively easy, what kind of losses are in store if liquidity measures break into "negative" territory? The S&P500 drew down 40 percent when liquidity tanked over the course of 2008, and 30 percent in the first few months of 2020. Bonds are thought to protect investors in the typical 60/40 stock/bond portfolio, but this protection is not robust, and most people I talk to don't have a bond allocation in their 401K.

Dark blue - S&P 500, light blue - Vanguard Diversified Bond Fund.

The 60/40 portfolio's return during this period was -29 percent, and it took five and a half years to break even on stocks bought near the 2007 peak.

A real turn towards illiquidity means a much more serious drawdown in asset prices than most people who own them are prepared for.

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