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.