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Want To Outperform The Market, Buy Illiquid Stocks (And Pray)

Tyler Durden's picture




 

As part of Bernanke's and now Yellen's experiment in market central-planning, in which newsflow no longer matters to a market that has lost all ability to discount anything except how big a central bank's balance sheet will be and where HFT momentum is far more important than fundamentals, one of the greatest investing perversions to emerge has been our finding from two years ago since confirmed on a monthly basis, that the best performing assets also happen to be the most hated ones, seen in the chart below as the most shorted stocks have outperformed the market more than twofold in just the past two years.

And now, even though it has been well-known by traders for years, academics appear to have finally uncovered one other "strategy" to consistently outperform the market: buy illiquidity, or as the FT puts it: "The less liquid a stock is, the better it will perform in the long run, compared with more liquid stocks."

Yes, apparently this is news, even though it has been known by pump and dumpers the world over for decades.

Don't believe us? Just ask Tom Laresca who, correctly, concluded that the CYNK pump and dump scheme du jour first uncovered here two weeks ago was an epic fraud and shorted it only to lose massive amounts of money and also his job. Why? Because as we showed on numerous occasions, the stock rose from less than a dollar to a market cap of over $5 billion (when the price soared above $20) on volume that was a fraction of a percent of its total outstanding shares.

So yes, traders sadly have known for a long, long time that the more illiquid a given asset is, the easier it is to pump it. Of course, there is also a flipside, and if and when the "story" ends, and the dumping begins, the entire bidstack disappears in a puff of smoke, resulting in an immediate repricing of the enterprise in milliseconds as opposed to liquid stocks where there are at least some buyers and short-coverers on the way down. 

However, in the new normal, where there is no downside risk courtesy of the abovementioned Federal Reserve, returns have been disproportionately skewed to the upside... another thing well-known to the trading community, if not to academia and the mainstream media it appears. To wit:

The financial academic community has now given this notion its imprimatur. This week, the Graham & Dodd prize (named for the academics who founded value investing) for the best 2013 article in the Financial Analysts Journal went to Yale School of Management’s Roger Ibbotson, long one of the best-known researchers into finance, for what may become a seminal article laying out why liquidity should join size, value and momentum.

 

Liquidity can be measured in many ways. The measure Mr Ibbotson and his colleagues chose was turnover – the proportion of a stock’s market capitalisation that changed hands on any given day. They then ranked 3,500 US stocks by their turnover and ranked them into four quartiles. This showed that the least liquid quartile, from 1972 to 2011, returned an average of 16.38 per cent, compared to 11.04 per cent for the most heavily traded stocks, and 14.46 per cent for the universe of stocks under control.

 

How much does this mean? In practice, this means that liquidity tends to overlap with “newsworthiness” or “popularity”. Stocks at the centre of attention like Google or Facebook are highly unlikely to show up as low-turnover stocks for many years to come. Stocks that are neglected and ignored will be relatively illiquid.

 

Overall, it found the difference between high- and low-liquidity stocks was similar to the difference between highest and lowest stocks when ranked by the other styles. Low-liquidity stocks tend to stay illiquid, meaning there is no need to keep trading in and out of stocks over time. And over the full 1972-2011 period, illiquid stocks fared better than small stocks and high-momentum stocks.

All of this, again, is known. An interesting tangent the FT goes into is why illiquid stocks, on average, don't get pounded as much as the broader market:

As illiquid stocks should be harder and more expensive to trade, it becomes harder for share prices to readjust smoothly, creating volatility. But in practice, the experience of the 2008 crisis was exactly the opposite. Daniel Kim, one of the co-authors and research director for Zebra Capital Management in Connecticut, reports that illiquid stocks suffered far lower drawdowns during the most dramatic days of heavy selling. That was because, in an emergency, people sold whatever they could, so liquid stocks were sold first.

Also known as the "gating" phenomenon: those hedge funds, usually the worst performing ones, during the crisis which gated survived. Those which outperformed or were even generating positive returns were promptly liquidated as investors scrambled to preserve whatever capital they could - this is the thinking in principle behind today's SEC announcement money market funds will henceforth have gates (which however backfires before the fact as it sends a message that the asset class is explicitly risky resulting in a preliminary "run on the bank" - something the SEC is counting on as it hopes the $2+ trillion in money market funds get reallocated into stocks).

Of course, "gating" only works to a point: had the Fed not stepped in to bail the entire system out, even those funds which gated would have been crucified, only instead of just being forced to release their capital, the PMs would have likely been forced to part with various body parts courtesy of furious investors.

The same logic goes for illiquid stocks: remember that CYNK was finally halted by the SEC, but only after suckering in yet another wave of momentum-chasers. Depending on how angry said chasers were, the management of the company and the SEC itself would have been subject to direct public fury. Only in this particular ponzi, there was a very small amount of participants to matter. But what happens when the entire market is involved?

The biggest irony is that as the entire S&P become less and less liquid as trading volumes collapse to unseen levels as the market rises ever higher, the "illiquidity" premium becomes very clear. This is what we said in our "take-home" message from the CYNK fiasco:

For all the drama and comedy surrounding the epic idiocy in which a bunch of "investors" took the price of non-existent company CYNK from essentially zero to a market cap of over $5 billion in under a week, most people missed the key message here: the stock is a harbinger of what is happening to the entire market. Because while those defending what is clear irrational exuberance, scratch that, irrational idiocy are quick to point out that CYNK's epic surge took place on less than 0.1% of its outstanding shares, these are the same people to say precisely the opposite about the S&P 500. "Ignore the collapsing volumes sending the stock market to all time high - it's perfectly normal" is an often repeated refrain by the permabullish crowd. Just not when it involves case studies in market insanity like CYNK apparently.

And it's not only stocks. Here is what RBS said earlier about the credit markets confirming all those TBAC fears we reported about last spring. From Bloomberg:

Liquidity declined about 70% since financial crisis, according to Alberto Gallo, strategist at RBS. He said that a decline means exit door narrower for investors when unwinding trades; the premium for illiquidity is at record low. It gets worse when adding equities: "Illiquid assets/daily liability mismatch in ETFs and mutual funds is similar risk to banks pre-crisis." Regulators’ focus on banks in response to crisis is ‘Maginot Line’ that can be easily circumvented.  Investors should avoid bonds held by retail investors and ETFs because they are most vulnerable to shocks.

So yes, illiquidity does result in outperformance: that much has been clear to market participants for ages and, now, to the media and academics. The problem is that said outperformance is always temporary and always comes at a price: it can and will only work as long as there is an implicit backstop - in the New Normal that being naturally Federal Reserve. It also always mean reverts, and once it does any ridiculous assumptions that illiquid stocks are spared from the selling hordes will be, pardon the pun, thrown out of the window.

But for now, expect the herding effect to come into play as an Alpha-starved population scrambles to find and piggyback on the next CYNK in hopes that the more illiquid, the higher it will rise. And with that, the stakes for the Fed's exist get even higher, because all those high flyers on zero volume will ultimately become zero flyers on massive volume when the rug gets finally pulled from below the market.

 

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Wed, 07/23/2014 - 09:59 | 4992570 slotmouth
slotmouth's picture

Buy illiquid stocks and pump.  Open up an exclusive chatroom, drop rumors in twitter and yahoo finance, etc.

Wed, 07/23/2014 - 10:11 | 4992636 AccreditedEYE
AccreditedEYE's picture

You forgot "sell Vol till you 'ball"

Wed, 07/23/2014 - 10:20 | 4992684 lordylord
lordylord's picture

He also forgot "print a trillion dollars every year"

Wed, 07/23/2014 - 10:45 | 4992810 slaughterer
slaughterer's picture

Looks like we get ES 2000, AAPL 100, and NASDAQ 4500 all at the same time this week.

Wed, 07/23/2014 - 10:03 | 4992581 Dr. Engali
Dr. Engali's picture

If anybody believes that the illiquid broader market isn't going to suffer the same fate they are fooling themselves. It's just a matter of when.

Wed, 07/23/2014 - 10:07 | 4992615 Peter Pan
Peter Pan's picture

Just remember this world has gone crazy so really it's not a question of "when" but a question of "if".

Wed, 07/23/2014 - 10:23 | 4992700 NoDebt
NoDebt's picture

The market has already crashed.  Just in an upward direction.

"There is no dark side of the moon.  It's all dark, actually."

Wed, 07/23/2014 - 10:04 | 4992590 Quinvarius
Quinvarius's picture

This market has yet to convince me it has not started to factor in the end of QE and the impending dump.  Because like when Japan ended every QE program and the market dumped right back to lows, so will the US.

Wed, 07/23/2014 - 10:09 | 4992621 Kreditanstalt
Kreditanstalt's picture

H.M.M. = Highly Manipulated "Market" today.  How can something so gasbag-like, so vastly overpriced, "the most liquid market in the world" waffle only between 1,982 1nd 1,984 points for TEN MINUTES NOW??????

OTOH, maybe there are no players left at all.

Wed, 07/23/2014 - 10:21 | 4992688 espirit
espirit's picture

Don't you wish you had that 10 minutes of your life back now?

This shitshow is a rerun of an old soap opera.

Wed, 07/23/2014 - 10:31 | 4992749 Al Huxley
Al Huxley's picture

Well for godsake, don't just sit there watching it - this may be today's dip!  You should be buying with both hands, not wasting time posting here!

Wed, 07/23/2014 - 10:09 | 4992625 AccreditedEYE
AccreditedEYE's picture

Notice the pattern this month? They are trying to consolidate gains without a sell off! If they can churn round the top, they avoid sell off and can rip us higher post 3rd quarter. Pay attention to the games they play... This is why all CNBS and MarketWatch headlines are extreme. "Crash", "Dow 20k" etc

Wed, 07/23/2014 - 10:20 | 4992683 NoDebt
NoDebt's picture

I think everyone has gotten numb to the "extreme" headlines.  We need something more extreme than extreme.  Like 'hyper-extreme', maybe.

Wed, 07/23/2014 - 10:23 | 4992701 espirit
espirit's picture

...or Normal Weather Saves the GDP!

Heh.

Wed, 07/23/2014 - 10:38 | 4992768 Quinvarius
Quinvarius's picture

If you do a quick mouse over of some basic commodity charts on this site:

http://finviz.com/futures.ashx

You will see the commodity markets are literally crashing through the floor, except meat chocolate and gold.  Some bad shit is going on.  I think they are trying to get out of the stock market before it implodes next.

Wed, 07/23/2014 - 11:08 | 4992936 AccreditedEYE
AccreditedEYE's picture

I respectfully disagree Quinvarius. While I'll give you there is *some* commodity churning going down I believe this will resolve itself and stabilize. If Druckenmiller was right, you would be seeing a whole lot of "front running" going on right now and we see none. I think path of max frustration is churn sideways then explode higher as the dollar falls into the tank.

Wed, 07/23/2014 - 12:11 | 4993353 Quinvarius
Quinvarius's picture

I am extremely cautious on stocks.  Japan stocks never held any gains after QE attempts.  As we wind down QE, we are facing the end of the speculative money hose.  I'd rather wait for the taps to come back on again, listen to a few Goldman market downgrades, and then buy.  In the end, inflation is bad for business.  I can only guess that the commodity markets are already pricing in the future.

Wed, 07/23/2014 - 10:35 | 4992770 passenger_pidgin
passenger_pidgin's picture

Newspeak Economics 101

Wed, 07/23/2014 - 10:48 | 4992827 techstrategy
techstrategy's picture

Now if they would analyze the impact of concentration of float (use Top 10 holders) and look at both underlying and option activity (and the ETF stuffing play from rebalancing), they'd really get to the mechanism through which these reflexive dynamics create extraordinary imbalance until the imbalance engenders its own instability and it all implodes.

 

Convert illiquid float scams into cash and gold today.  Let those responsible buy the market they broke.

Wed, 07/23/2014 - 11:23 | 4992975 Mercury
Mercury's picture

The SI chart is interesting (although I'd like to see it redrawn ex-Bill Ackman stocks!) but how is the Ibbotson data not just a tale of survivorship bias?

Don't the worst performing illiquid (and small-cap one presumes) stocks eventually just leave the universe being studied one way or the other - leaving a higher concentration of less liquid outperformers?

Also, who knows how much QE has affected relative outcomes one way or the other but the 5yr total returns for the SPX and RUT are just about tied right now.

Wed, 07/23/2014 - 11:20 | 4993010 the grateful un...
the grateful unemployed's picture

corner the market in an illiquid stock, beat up on the short sellers, by controlling the float, and then get some friends to help you levitate the value on low low volume. jsut remember pigs get fat, but hogs get slaughtered, so don't get too crazy

Wed, 07/23/2014 - 12:24 | 4993385 combatsnoopy
combatsnoopy's picture

ACCORDING TO THE CHICAGO FEDERAL RESERVE (appeal to authority---hack!)

"A handful of high-frequency trading firms accounted for an estimated 70 percent of overall 

trading volume on U.S. equities markets in 2009."  http://www.chicagofed.org/digital_assets/publications/chicago_fed_letter...

There hasn't been any liquidity in our markets.  

Then on the next articles- it elaborates on "FINANCIAL MAREKT UTILITIES" to liquidate the illiquid.  So this is why the banks are liquid?  

This vast flow of payments happens largely below the radar screen of most people, thanks to a collection of institutions known as financial market utilities (FMUs). The basic function FMUs perform is simple. After a financial trade has been agreed upon, a mechanism must exist to convey the financial asset from seller to buyer and reciprocally to convey compensation from buyer to seller. FMUs provide this mechanism. In particular, FMUs mitigate settlement risk (the risk that trades will not be settled or completed as expected) and the particular form of settlement risk known as counterparty credit risk (the risk that a party involved in a transaction might fail to deliver funds or securities as promised).

http://www.federalreserve.gov/paymentsystems/designated_fmu_about.htm

Where the heck were FMUs during the Enron collapse?  

 

Post Edit: "To date, the Council has designated the following FMUs as systemically important (Supervisory Agency indicated in parentheses):

  • The Clearing House Payments Company, L.L.C., on the basis of its role as operator of the Clearing House Interbank Payments System - (Board);
  • CLS Bank International - (Board);
  • Chicago Mercantile Exchange, Inc. - (Commodity Futures Trading Commission (CFTC));
  • The Depository Trust Company - (Securities and Exchange Commission (SEC));
  • Fixed Income Clearing Corporation - (SEC);
  • ICE Clear Credit L.L.C. - (CFTC);
  • National Securities Clearing Corporation - (SEC); and
  • The Options Clearing Corporation - (SEC).

ICE-International Currencies Clearing house regulated by the CFTC?  That SAME CFTC THAT WASN'T PICKING UP IT'S PHONE DURING THE SUBPIRME SCANDAL?  

CLS- where was the Board PRIOR to the Subprime Collapse? 

CME- again the inept CFTC.  The same CFTC that is in violation of RICO and Obstruction of Justice charges (I documented the cases and laws on that blog)

"WEDNESDAY, OCTOBER 20, 2010

RETIRING CFTC JUDGE: WE COVERED UP MARKET MANIPULATION

 

NEW DEVELOPMENTS IN THE CFTC SCANDAL: ON SEPTEMBER 17, 2010, CFTC ADMINISTRATIVE LAW JUDGE, GEORGE H PAINTER, ISSUED A "NOTICE AND ORDER" ANNOUNCING HIS RETIREMENT FROM HIS POSITION. IN THIS NOTICE JUDGE PAINTER WROTE OF A CONSPIRACY AT THE HIGHEST LEVELS OF THE CFTC (WITHIN THE ENFORCEMENT DIVISION) WHERE A LONG TIME JUDGE OF 20 YEARS HAS BEEN CONSPIRING WITH PAST CFTC CHAIRS TO RIG THE ENFORCEMENT OF THE LAW BY NOT FINDING ANYONE GUILTY OF MARKET MANIPULATION. HERE ARE JUDGE PAINTER'S OWN WORDS:

"THERE ARE TWO ADMINISTRATIVE LAW JUDGES AT THE COMMODITY FUTURES TRADING COMMISSION: MYSELF AND THE HONORABLE BRUCE LEVINE.

***ON JUDGE LEVINE'S FIRST WEEK ON THE JOB, NEARLY TWENTY YEARS AGO, HE CAME INTO MY OFFICE AND STATED THAT HE HAD PROMISED WENDY GRAMM, THEN CHAIRWOMAN OF THE COMMISSION, THAT WE WOULD NEVER RULE IN A COMPLAINANT'S FAVOR.***

 A REVIEW OF HIS RULINGS WILL CONFIRM THAT HE HAS FULFILLED HIS VOW. JUDGE LEVINE, IN THE CYNICAL GUISE OF ENFORCING THE RULES, FORCES PRO SE COMPLAINTS TO RUN A HOSTILE PROCEDURAL GAUNTLET UNTIL THEY LOSE HOPE, AND EITHER WITHDRAW THEIR COMPLAINT OR SETTLE FOR A PITTANCE, REGARDLESS OF THE MERITS OF THE CASE"

HTTP://WWW.WASHINGTONPOST.COM/WP-DYN/CONTENT/ARTICLE/2010/10/19/AR2010101907216.HTML

SEEKING WSJ'S DEC 2000 ARTICLE: DECEMBER 2000 WALL STREET JOURNAL STORY BY MICHAEL SCHROEDER TITLED, “IF YOU GOT A BEEF WITH A FUTURES BROKER, THIS JUDGE ISN’T FOR YOU—IN EIGHT YEARS AT THE CFTC, LEVINE HAS NEVER RULED IN FAVOR OF AN INVESTOR” THAT DETAILS LEVINE’S PENCHANT FOR FAVORING BROKERS OVER INVESTORS SEEKING REPARATIONS.

 

THERE HAVE BEEN PERFECTLY LEGITIMATE CASES AGAINST THE SUBPRIME DEALERS OF FRAUD BY INVESTORS, ETC. THAT WERE DISMISSED BY THE JUDGES, ERRONEOUSLY CITING THE SECURITIES ACT OF 1933 (WHICH WAS ENACTED TO PROTECT INVESTORS).

HTTP://WWW.DANDODIARY.COM/2010/06/ARTICLES/SUBPRIME-LITIGATION/AN-UPDATED-ANALYSIS-OF-SUBPRIME-SECURITIES-SUIT-DISMISSAL-MOTIONS/

HTTP://WWW.DANDODIARY.COM/2008/06/ARTICLES/SUBPRIME-LITIGATION/THE-LIST-SUBPRIME-LAWSUIT-DISMISSALS-AND-DENIALS/INDEX.HTML

HTTP://WWW.SKADDEN.COM/CONTENT/PUBLICATIONS/PUBLICATIONS1962_0.PDF"

http://economicasylum.blogspot.com/2011/04/cftc-is-guilty-of-obstruction...

So much for the legitimacy of the CFTC.  So how are the foreign holders of US Debt holding these people up to quality control?  

 

Liquidity.  Who needs that damm liquidity? 

Wed, 07/23/2014 - 12:17 | 4993391 SMC
SMC's picture

Economic reality is starting to bang loudly on the doors of the tenured academics who are too busy adjusting student grades to counter alleged "discrimination" - not only do they overcharge for alleged knowledge transfer, they are doing their best to make the degrees worthless as well...

http://www.mindingthecampus.com/2014/07/an-amazing-diversity-plan-at-mad...

Yep, made me puke too.

As to the current "free market" fantasy of "... no downside thanks to the Federal Reserve.".

ROFL! The downside is worthless dollars, rampant incompetence due to cronyism and low demand from anyone with the ability to pay.

Watching them spin this slow motion train wreck is hilarious.

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