9. The Third Factor: Liquidity—Follow the Money

If you don’t have it, you can’t spend it.

That’s one of those life lessons that all of us learn at some point along the way, together with the ugly inevitability of death and taxes. Money is a finite commodity, and all of us must consider that whenever we make our spending decisions. In other words, before plunking down the cash for that Hawaiian vacation, you need to consider your liquidity position. Do you have that money available to spend? If you spend it on that vacation, what will you not be able to spend it on? Will you be able to replace that cash through fresh earnings and, if so, how quickly?

These are just some of the questions that a discussion of liquidity sparks at the personal level. From our earliest years, we all begin to be aware of how available money is—how easily it can be acquired—and the need to make spending decisions. When you’re a child, how much cash you have in your pockets (your liquidity position) depends largely on your parents. When my two daughters, Elise and Emily, were young enough to be entirely dependent on us for their cash flow, we lived in Florida. Every weekend, we could head for one of the state’s seemingly endless array of theme parks in which the girls could run amok. Being able to take our children on fantasy vacations on a regular basis was wonderful, but I dreaded certain aspects of each such excursion, particularly the mandatory trip to the souvenir shops. The endless array of plastic, nylon, and plush trinkets was daunting and so, too, was the clamor of our daughters for one after another of these objects. My wife and I knew that we would never be able to persuade either girl to just walk away from this junk. Instead, we used liquidity considerations as a way to instill reasonable behavior. We’d capitulate, but intelligently, by giving each girl $20 to spend each day as she wished. She could fritter it away or save both days’ allowances to make one big $40 purchase. This liquidity-based approach transformed our daughters into discriminating comparison shoppers. Faced with a finite amount of capital, they still spent it all; what else could be expected? Elise, at the age of eight, was the more aggressive spender; the $20 disappeared the day it was dispensed, and she would sometimes plead for an advance on the second day’s allowance. But Emily, then age four, hung on to her capital until the end of the second day for a single shopping spree.

What, you ask, does this have to do with liquidity? The degree to which our girls had money in their pockets depended on our access to capital as well as our willingness to finance their shopping excursions. With their $20 a day, Elise and Emily could then decide whether to contribute their dollars to the theme park’s revenues, boosting its own liquidity. In fact, our weekend adventures served as examples of the two major kinds of liquidity: funding liquidity (our willingness to make capital available; to serve as our daughters’ bankers) and market liquidity (our daughters’ ability to easily spend that capital on miscellaneous stuffed animals).

Liquidity is the third factor in my model because without it financial markets and even economies cease to function efficiently. Someone out there—a central bank, an employer, a parent, or an elderly aunt writing a will—serves as a provider of liquidity, and the endless to-and-fro sloshing of liquidity from one part of the economy to another ends up powering the economy and financial markets.

The best illustration of liquidity’s importance I have ever heard came from a friend of mine, Jane Esser, who once told me to think of liquidity as if it were gasoline, and companies as automobiles. “It doesn’t matter if you run a Bentley or a Yugo, without liquidity, you’ll grind to a halt.” What’s true for automobiles is the same for corporate America. The deeper the pool of liquidity and the more accessible it is, the easier it is for economic growth to occur and for stock prices to gain ground. When liquidity becomes less abundant, the economy and markets alike become more subject to retreats of various degrees of magnitude. The troubles of insurance giant American International Group (AIG), for instance, can be traced to a lack of liquidity (the firm’s inability to sell its assets at anything approaching their true value). The value of its assets exceeded that of its liabilities, but in the absence of a market for those assets—in an absence of liquidity—that didn’t matter. The 2008 government bailout of AIG became inevitable because the liquidity that is available in most conditions and is required to operate simply evaporated.

Essentially, liquidity is a gauge of how much money is flowing through all parts of the financial system. And just as happens at Disney World, when there is cash around, spending and investment often follow. At first glance, it seems foolish for luxury retailers to open large boutiques in Las Vegas. After all, don’t casinos win all the time at the expense of their customers? So why would visitors spend their money in these retail outlets? But the realities of liquidity triumph. There are some winners in Las Vegas. And there is lots of liquidity, generated both by those winners and by losers, who come to Las Vegas with lots of cash and are quite willing to squander what cash they haven’t already lost to the slot machines on a new handbag or a high-end watch. Las Vegas is a temple to the gods of liquidity.

When liquidity evaporates, as we witnessed throughout the autumn of 2008, any securities market can turn sour very quickly. Traders worriedly scour a slow-moving market in search for signs that a “buyer’s strike” may be in the offing. In this worst-case scenario, buyers vanish altogether, either because they don’t have access to capital to invest or spend or because they are too fearful to put that capital to work. (In 2008, the culprit was counterparty credit risk, aggravated by the bankruptcy filing of Lehman Brothers; banks were afraid to lend to one another for fear that the borrower would collapse with the loan still outstanding.) Indeed, there’s an important link between investor psychology and liquidity across the entire economy. When money is available to us—when our salaries rise, when we get a bonus—we are more likely to invest or spend. And when we feel our jobs might be at risk, or that we may need our spare cash for medical bills, for instance, we pull back. We start shopping at Target rather than at Saks Fifth Avenue.

Keeping an eye on liquidity metrics can alert us to problems and opportunities. In early 2008, suspecting liquidity would be an ongoing issue for the financial markets, I built a liquidity “dashboard” to measure how easily companies could access new capital should they need it. One key metric it involves is the value of the Japanese yen. Because hedge funds tended to borrow money by shorting yen, a rise in the yen’s value would tell me that hedge fund borrowing was falling. I also looked at credit spread changes, because widening spreads would warn me that lenders were becoming more cautious. I added metrics dealing with stock and bond market volatility to round out my dashboard, so that if liquidity deteriorated, a whole host of warning lights should start to flash. With my new metrics-driven tool, I could monitor liquidity levels on a daily basis, the same way a meteorologist tracks changes in weather conditions. By February 2008, liquidity had begun to dry up, market volatility was spiking, and credit spreads widened. Still, the yen’s value remained little changed, suggesting that hedge funds, at least, still had ample funds. Then in September, the yen abruptly spiked, signaling trouble in the hedge fund world. Suddenly, those leveraged players no longer had access to the credit on which their investment strategies depended, and many were forced to put entire portfolios up for sale at whatever prices they could obtain. Clearly, liquidity played a significant role in leading to—and signaling—the gargantuan selloffs in stock and bond markets that began that month.

As investors, we need to ask ourselves about the state of liquidity just as we want to know about what is happening in the economy and to become aware of any changes on your side or outlook for the stock market. Is the liquidity trend on your side, or are you trying to fight the trend? That’s the question you need to ask, and metrics that help you address it collectively represent the third factor. In evaluating liquidity, you need to know whether the liquidity trend is in your favor. The degree to which money is readily available and investors are prepared to allocate it to the market isn’t a primary driver of stock market returns over the medium to long term, especially when compared to factors such as the economy or fundamentals. But, in the absence of liquidity, defined as a steady inflow of new capital into the stock market, it’s hard for a rally to endure.

Even novice traders try to monitor the extent to which a market advance is “confirmed,” as trading desk jargon puts it, by the number of trades that contribute to that move. Market veterans are prone to view an outsize move in the Dow Jones Industrial Average or other index—say, a 350-point move rise in the Dow benchmark—that takes place amid thin trading as less bullish than a smaller one of only 150 points or so in the midst of a lot of buying. The latter, they know, signals a greater degree of conviction and thus a greater likelihood that the move will prove lasting. I’m not talking about a 1-day event when a group of hedge fund managers are sideswiped by a poor earnings report. Their selling is likely to be met within a day or two by bargain hunting by longer-term investors and normal tight spreads between prices bid and offered for the stock are likely to return quickly. Rather, I’m thinking of what happens when those buyers fail to show up on the day after a selloff (when the only people eager to trade all want to sell). That is the kind of market investors like myself struggled through in October 2008, when, for eight ugly sessions in a row, the Dow average slumped as much as 700 or 800 points, each day, every day. That kind of market, left unchecked, can turn into a death spiral as poor liquidity damages both prices and investor confidence, which in turn further damages liquidity.

Liquidity comes into play at all levels of the financial markets. Individual securities have their own liquidity dynamics, and so do industry sectors and asset classes. In a perfectly liquid market, there are so many buyers and sellers that any transaction, regardless of whether it is a purchase or a sale, can be executed without having to offer a market value discount to facilitate a quick sale. Over short periods, a lack of liquidity means there are fewer buyers than sellers, and the same is true in reverse, creating artificial demand and, if left unchecked, a bubble. When AIG fell victim to a lack of liquidity, it was because it couldn’t sell assets at their “true” worth because there were no buyers with capital to transact business and therefore the firm couldn’t realize the value of those assets. The higher up the food chain liquidity becomes an issue for the market, the bigger problem (or opportunity) it becomes, and the greater the number of investors affected. If the liquidity in a single stock evaporates, that will hurt only that stock’s owners. As the credit crunch of 2007 and 2008 showed, however, the lack of liquidity across global credit markets affected everyone from the smallest individual investor up to and including powerful central banks and their governments. Indeed, the latter took unprecedented measures in repeated efforts to inject liquidity into the markets and stave off complete paralysis in the credit markets and an economic recession. In some ways, the Federal Reserve serves the role of parents of importunate children at amusement parks: They are the lender of last resort, when there is no liquidity forthcoming anywhere else. And when even the Fed can’t work its magic, as happened in October 2008, it’s up to the government itself to step in and restore order by getting capital flowing again, even when that comes with a $700 billion price tag.

Keeping an eye on liquidity can help us distinguish between market slumps that are really buying opportunities and those that are signs of serious economic problems. In the market retreats of the autumn of 1998 and the autumn of 2000, stock prices were falling, and the spreads on corporate bonds were widening, signaling that investors were becoming more averse to taking market risks. But analysts who paid attention to the market demands for credit and money could detect a difference between the two periods. In the final months of 2000, liquidity was sluggish, these pundits concluded. They reached that decision after looking at the growth in money supply, or M2 as it’s known on Wall Street, a figure that represents all cash-like balances held in everything from savings and checking accounts to bank-issued CDs. In 1998, M2 was still robust. Financial markets, flush with cash, rebounded, and the stock market rally resumed. In contrast, the slump in liquidity in late 2000 did presage a bear market that lasted 3 years.

I have found that it’s possible to monitor a wide array of liquidity-related metrics, starting at the very top with the amount of money the Federal Reserve itself is prepared to allow all the players in the economy to have at their disposal. (Think of this as the central bank’s equivalent of each of my daughters to spend, say, combined with how much we spent on ride tickets and food items, along with the spending of the thousands of other parents in each theme park that day.) One of the first questions to ask is whether the Fed and other lenders throughout the financial system are making it easy or difficult for us to borrow. The easier it is to obtain money, the greater the liquidity and the greater the potential for some of that capital to flow into the stock market. Low interest rates are one signal that can mean borrowing is “easy” and that credit is widely available. It’s a bit more complicated in practice because borrowers have different credit ratings, borrowing needs, and time horizons, while lenders have different cash reserves and lending criteria. Just because the interest rate on a Treasury security happens to be low doesn’t mean that liquidity is plentiful.

To understand how the liquidity process works, I’ll show you how the interest rate of a 10-year bond issued by a corporation is typically calculated. The first question is how much return lenders are demanding in exchange for tying up their capital for 10 years. A good basis for comparison is the yield of inflation-protected Treasury notes—the closest thing that there is to a risk-free return, insulated from the impact of inflation over that period. In early 2008, that 10-year “real” rate was 1.47%, signaling that the Treasury would pay that amount annually to individuals or institutions willing to buy these securities. That’s at the low end; yields on these securities have ranged from as high as 4.33% to as little as 1.28%, and averaged 2.78%. But a corporate lender (a bank) needs to be compensated for the potential impact of inflation on their returns (for any erosion in the purchasing power of their capital while it is in the hands of the borrower). Therefore, both borrower and lender have to agree on what kind of inflation is likely, and then adjust the interest rate upward accordingly. In early 2008, when the inflation-protected Treasury note yielded 1.47%, the yield on the 10-year fixed-rate Treasury note was 3.77%: The difference, 2.3 percentage points, represents that inflation premium.

Of course, lending to the corporate world involves more risk than lending to the U.S. Treasury! Even General Electric, although it carries the same triple-A rating (although the company has since been downgraded) from credit rating agencies as does the Treasury, is seen by lenders as a bigger credit risk. So, just as they want to be compensated for inflation risk, lenders want a few extra percentage points in yield in exchange for that additional credit risk. This difference, known as the credit spread, varies immensely depending on the category of issuer, the economic conditions and outlook, and the general liquidity environment. If Moody’s Investor Service concludes that ACME Widget Co. is a poor credit risk, ACME’s borrowing costs will soar, and the credit spread will widen. Or if XYZ Retailers reports higher earnings tomorrow, their credit spread may narrow as lenders believe the risk that they won’t be repaid has fallen. As of this writing, an issuer with a triple-B credit rating from one of the agencies can be expected to pay a relatively high rate, 2.51 percentage points above what the Treasury would have to pay in exchange for a 10-year loan. In tough economic times, investors tend to require a higher yield to lend to lower-quality borrowers.

Other factors are also at work. If a company’s bonds aren’t very easy to trade—either because there aren’t many around or because they appeal to relatively few investors—lenders will demand a further premium to compensate for that lack of secondary market liquidity. (This is often seen in the private placement market, for instance, where securities rarely change hands.) Pricing can be further complicated by any special terms or provisions associated with the loan. For instance, if a company wants to be able to buy back its bonds later to reduce its interest expenses, the cost of that “call option” may be another percentage point or two in yield. After all, if the option is exercised, the lender would then have the hassle of having to reinvest their capital. (Borrowers do try to buy back or refinance debt if interest rates fall or their cash position or needs change dramatically.)

So rather than interest rates, yield spreads turn out to be the metric that is most useful in understanding liquidity in the financial system. For instance, if you are interested in what is happening to industrial companies, you can measure the current yield on bonds issued by industrial firms with similar credit ratings and features to those issued by the Treasury. Then compare that yield spread to the historical yield spread for that group. When the only thing that is different is the time period (today, compared to 6 months or a year ago), you can tell whether capital has become more available or more scarce for the sector depending on whether spreads have narrowed or widened. That will tell you a lot about how willing lenders are to take different kinds of risks, and how much liquidity is truly present in different parts of the market.

Analyzing the finer points of credit spreads is one of those pastimes that bond geeks adore but individual investors tire of quickly. So let’s move to the other end of the liquidity spectrum, where it is possible to identify and track a different array of liquidity-related metrics based on money flows. Analyzing this data can help us understand the extent to which liquidity is ample or scarce, and thus whether this factor is likely to boost or impede a particular asset class’s future performance. These metrics can also help us identify areas in which liquidity levels are changing. One of the best-known examples of money flow metrics are mutual fund flows. This data, reported weekly or monthly by specialist groups, shows how much investors are allocating to certain kinds of mutual fund (inflows), how much others are withdrawing (outflows), and the net impact, whether positive or negative. The theory is that over time, tracking flows will give you a broad picture of liquidity in the shape of the number of dollars flowing into (or out of) mutual fund coffers. You can also drill down more narrowly and see what is happening within key sectors such as technology stocks, where a significant number of dedicated technology funds exist. Some pundits called the outsize returns provided by the volatile Chinese stock market between 2005 and 2007 a triumph of liquidity over fundamentals; investors, carried away by the excitement surrounding the prospect of betting on the future spending of 1.3 billion Chinese citizens, threw money into China-themed stocks and funds at a frenzied pace even as valuations soared.

I find the most useful mutual fund flows data comes from the world of closed-end mutual funds. As I’ve already explained, whenever a new investor appears on the horizon at an open-end fund, the fund company simply creates new shares in the fund to sell to him or her and then invests the new cash alongside that of existing investors. But when a new investor wants to buy shares of a closed-end fund, he or she has to buy shares of the fund from a willing seller. If there is a greater demand for the shares of, say, large-cap value stock closed-end funds than there is a supply of existing investors prepared to sell at the prevailing price, that price will rise and may even exceed the net asset value of the fund. That may seem illogical—why should people be willing to pay more for a collection of stocks that they could buy more cheaply elsewhere? But it does happen in the world of closed-end mutual funds, whenever an individual manager, fund, or asset class becomes so compelling that investors bet on future potential rather than current values. Liquidity takes over. Similarly, if there aren’t enough willing buyers to snap up shares in the closed-end fund, the stock price can fall to a discount to its net asset value.

Monitoring these closed-end fund premiums and discounts offers an insight into liquidity trends, particularly investors’ appetite for certain asset classes at varying times and in varying circumstances. For instance, the Nuveen Real Estate Income Fund (a closed-end fund), which trades on the American Stock Exchange under the symbol JRS, traded at a hefty discount to its net asset value when compared to its average over time. (The fund was launched in November 2001.) But beginning in February 2006, the fund’s average discount to net asset value began to shrink. By that August, it was trading at a small premium for the first time since 2002. The move suggested that the fund and its asset class were both becoming more popular. Not surprisingly, the fund’s premium to net asset value peaked in December 2006, the same month that the market for real estate investment trusts as a group peaked ahead of the downturn in the real estate market that lay ahead the following year.

Big liquidity changes can be particularly visible and important in smaller markets like real estate investment trusts (REITs). Even after massive inflows in 2006, the global REIT market had only $764 billion in assets, according to Ernst & Young. Consider the Dow Jones REIT exchange-traded fund (or ETF), which is listed under the symbol IYR. This fund is one of the most popular vehicles among investors interested in gaining exposure to publicly traded REITs. In contrast to closed-end funds and like mutual funds, the architects of ETFs simply create more shares to accommodate new investors and retire shares to satisfy redemptions. Therefore, tracking the number of shares outstanding of any ETF over time gives us some insight of the amount of liquidity flowing into its asset class. In the case of the REIT market, IYR is a great proxy for liquidity. The fund was launched in June 2000 with 300,000 shares. Within a week, that number had nearly doubled to hit 500,000. By December 2006, the last year in which the sector saw strong returns, the number of shares of IYR outstanding had multiplied 44-fold (see Figure 9.1). For every year of its existence, the number of IYR shares had increased at an astounding annualized rate of 90%. When you see liquidity grow at that kind of dramatic pace—especially when the growth is associated with a relatively small asset class—you shouldn’t ignore it. Indeed, anyone who followed liquidity and invested in REITs for that 6-year period did very well. Of course, liquidity can be less reliable as an indicator when analyzing larger asset classes or even large sectors, because the impact of a determined amount of inflow (or outflow) will always have a smaller impact on larger pools of capital.

Figure 9.1 Dow Jones REIT exchange-traded fund.

Of all the different kinds of liquidity that investors can monitor, perhaps most crucial of all is what I call “big liquidity.” This is the kind of liquidity controlled by central bankers such as Alan Greenspan, Ben Bernanke, and their peers at the Bank of Canada, the European Central Bank, the Bank of England, and other major central banks. When individuals turn our own personal spigots—when we collect our bonuses and spend or invest them, when we open up a new line of credit, when we give money to our children to spend in theme parks—we give liquidity a small boost. But unless vast numbers of us act in roughly the same way at roughly the same time, there is no way that we can approach the impact of a central bank’s decision on a macro basis to make liquidity more available to all of us. In normal times, central bankers perform a kind of monitoring service: They evaluate liquidity levels elsewhere in the financial system. Do banks have enough cash on their balance sheets, and are they willing to make that available to qualified borrowers? What other pools of capital can an investor draw on? If other sources of liquidity vanish (as happened throughout the credit crunch), it falls to the central bankers to open the spigot to allow new cash flow into the market and, hopefully, fuel the market. As we all saw in 2007 and 2008, that can be accomplished in a straightforward manner, by lowering interest rates, or through more complex maneuvers that put more capital in the hands of commercial lenders and give them incentives to send that money out into the hands of borrowers.

A first step in monitoring “big liquidity” is keeping an eye on what’s happening with M2—that measurement of money supply growth that conveniently tracks how much cash-like assets all of us collectively possess, which is calculated and disclosed monthly by the Federal Reserve. When M2 surges, that’s good news for stock market returns. The degree to which the economy can grow—a critical ingredient in stock market performance, as I discussed in the preceding chapter—depends on the rate of growth in money supply. If money supply grows faster than inflation, that’s bullish for stocks because money is becoming more abundant. All things being equal, more money available means more money that is borrowed or given and more money spent. Still, if production grows faster than money supply over long periods of time, that can have a downside. As money becomes scarce, the cost of borrowing rises, the economy slows, and spending falters. It’s a bit like a coal-fired steam engine. As long as the fireman shoveling coal into the boiler can do so with just the right amount of coal on his shovel and at just the right speed, the engine chugs along at just the right pace. Too much steam, too little coal, or an exhausted fireman unable to keep up the pace—all alter the picture; the train slows down or the boiler overheats.

In normal times, the central bankers serve more as monitors of liquidity than as actors. When they do decide to inject new liquidity, they must gauge how much capital is needed to jump-start the financial markets, and determine when the liquidity crunch has subsided. That can be difficult because central bankers are often combating perceived risks as much as they are real ones. For instance, Ben Bernanke and his fellow Fed policy makers were particularly active in late 2007 and throughout 2008, coordinating large-scale infusions of liquidity into the financial system and often using unusually creative mechanisms. But the credit market problems unleashed by the subprime lending debacle were large enough that interest rate cuts alone weren’t enough. The central banks were signaling as strongly as they could that they wanted borrowers to access capital, that they were willing to let borrowers get access to capital at a lower cost, but for some reason that capital wasn’t making its way into the economy. Perhaps banks needed to shore up the holes in their own balance sheeting, or borrowers, fearful of a looming recession, didn’t want to take on new debt. Whatever the reason, money wasn’t moving; there was negative liquidity. That kind of pattern, left unchecked, spells disaster for financial markets because it leads to volatile markets in which it’s impossible for anyone to execute a purchase or sale of securities smoothly.

Central banks confronting this kind of crisis can jump-start the economy with a well-timed infusion of liquidity. But leaving that cash spigot turned on full force for a prolonged period of time is dangerous, because too much liquidity can create inflationary pressures that may prove equally hazardous. Central bankers now are all too aware of the risks of too much “easy money” (capital that is available at an interest rate that is lower than the growth in GDP). Indeed, it was the willingness of the Federal Reserve to accept that kind of interest rate policy beginning in early 2002 that set the stage for the biggest housing bubble in American history, complete with all the usual excesses: investors using their homes as ATMs to mis-selling of poorly designed mortgage products.

Part of monitoring metrics, therefore, means keeping tabs on not only the direction of interest rates and economic growth, but on the relationship between them. When that relationship is taken to extremes, it spells trouble either for lenders or borrowers. For instance, a central bank that is keeping interest rates above the rate of GDP growth is sending a clear message that it doesn’t want to risk the inflationary pressures that go hand in hand with low interest rates and so won’t put money in investors’ pockets with which the latter can speculate. That kind of gap between growth rates and lending rates means borrowers will have to be much more cautious in how they invest their own capital. The liquidity crunch makes its way throughout the financial system in this manner: As the Federal Reserve policy makers turn off the flow of cash, so investors respond by being picky about what they do with the smaller amounts they can afford to borrow, looking carefully through the array of possible investments for those they believe have the potential to grow at a faster clip than the overall economy. Those investments that don’t meet their criteria will find investment capital hard to come by, and a liquidity crunch starts to take shape.

One way to detect liquidity problems is to monitor what is happening with the credit spreads that I discussed earlier. In the summer and fall of 2007, for instance, credit spreads widened suddenly and dramatically, as investors fled corporate bonds for the perceived safe haven of Treasury securities. That was a characteristic of an illiquid market, one in which corporate bonds and their issuers could offer higher and higher interest rates and yields without attracting buying interest. That’s the reverse of the situation that prevailed between 2002 and 2007, when abundant liquidity, starting at the top with the central bank and its low interest rate policy, caused spreads to narrow between the yields on the most stable of assets (Treasury bonds) and securities issued by companies perceived as risky investments, either because they were laden with debt or had doubtful earnings growth prospects. The greater the amount of liquidity, the narrower the spread between these two groups; when cash is abundant, investors display a greater appetite for speculative securities. Therefore, when I want to understand how risk tolerant or risk averse investors are, credit spreads and the data they give me about credit risk can be helpful.

Why do I care how much appetite for risk investors have at any given moment? Because history has shown us that a growing appetite for risk—the kind that shows up in wider bond market spreads—tends to be linked to periods of healthy stock market returns. A host of specialized rating agencies assign ratings to every bond that is sold publicly to investors, with triple-A as the top rating (awarded to many government bonds and companies with perfect credit scores and pristine balance sheets). A double-A or single-A rating (or even an A minus) is still an investment-grade credit rating. But anything below a triple-B rating is viewed as much more speculative; many investors’ guidelines ban them from buying these securities. But tracking the spread between the yields on these risky bonds and those of “risk-free” Treasury securities can tell me a lot about both liquidity and the appetite for risk on the part of the market as a whole. Between 1992 and 2007, for instance, 10-year corporate bonds with a speculative double-B rating yielded only about 2.4 percentage points more than 10-year Treasury notes; that’s all that investors wanted in exchange for taking on the extra risk. Studying the historical performance of the Dow Jones Industrial Average, I found that whenever investors demanded more than 2.4 percentage points of extra yield before they would buy the BB-rated bonds, stock markets tended to struggle, returning only 2.6%.

The same Harris Private Bank study of the use of credit spreads as a market liquidity indicator suggested that credit was relatively easy and liquidity was flowing. In this case, liquidity served as an “environmental” indicator, telling us that liquidity was readily available enough that risk taking would be rewarded. In that kind of risk-taking environment, stocks are likely to fare well. So, I concluded after examining this study’s results that a strong metrics-based argument seems to exist for staying invested in stocks when credit is easy and liquidity abundant, and for becoming cautious only when lenders begin to restrict credit. On the flip side, tighter credit conditions in the first half of 2008 suggested that investors were becoming risk averse and that making money in the stock market could be difficult (see Figure 9.2).

Figure 9.2 “Tight” and “easy” credit.

The study my team conducted at Harris Private Bank began by dividing the credit cycle into four phases. We defined the “expansion” phase as one where credit was tight and credit spreads were widening; the “peak” phase was characterized by tight credit and narrower credit spreads. In the “contraction” phase, credit was readily available as credit spreads narrowed. The “trough” phase saw easy credit and wider credit spreads. We reached back to June 1992, and put each month into one of those four categories. Then we calculated the performance of the Dow Jones Industrial Average for the 12-month period following each of those months.

The results confirmed our suspicions that credit and liquidity were reliable indicators of stock market out- or underperformance. The stock market fared worst after periods when credit had been tight: On average, the Dow returned 3.5% in the yearlong periods following an expansion reading and only 1.4% after peak phases. In contrast, when credit became readily available, the stock market tended to thrive. The Dow fared best after a contraction phase, with easy credit and narrower credit spreads, returning an average of 14.9% in subsequent yearlong periods. In the wake of a trough, the Dow returned an average of 13.3%. Trying to focus our study results on the essential question, we found that the Dow surged 14.2% in the wake of a period of easy credit conditions but only 2.6% after tight credit conditions (see Table 9.1).

Table 9.1 Dow Changes Source: Harris Private Bank, Innovative Solutions Team

The equation is straightforward. Narrow credit spreads are consistent with easy money. Easy money is another name for strong liquidity. For evidence, you don’t have to look any further than the housing bubble. Lenders went overboard injecting liquidity into the real estate market from 2002 right through to the end of 2006, offering “teaser” rates, waiving down payments, and signing off on “liar” loans without verifying borrowers’ incomes. Not surprisingly, the median price of a single-family home soared during the same period. Only when it became impossible to ignore the bubble did lenders pull in their horns, raise their lending standards, require higher credit scores, and even shut down lending to borrowers who didn’t qualify. Credit spreads widened, liquidity evaporated, and the housing downturn worsened.

Wider spreads consistently signal that lenders are reluctant to extend credit—and they send a broader message that liquidity is constrained. This is true across a variety of markets, including stocks: Periods of wider credit spreads tended to correspond with monthly returns on the Dow Jones Industrial Average of only 0.8%. Whether that is due to a shortage of capital available to lend or to a general skittishness on the part of lenders, the result is that wider spreads drive up de facto borrowing costs and cause liquidity to evaporate.

So far, I have discussed liquidity metrics as a tool that can tell me when stock markets are poised to benefit from a flood of cash or credit markets likely to seize up as liquidity evaporates. However, these measurements can also prove useful when looking within the stock market. Understanding liquidity can help me evaluate the relative merits of different market sectors, such as whether larger blue-chip stocks appear likely to outperform their smaller counterparts, or vice versa. The kind of “little liquidity” I have described above—the willingness by investors to put their capital to work in riskier assets and asset classes—plays a role here, as well.

The stock market’s abundant liquidity had a disproportionately positive impact on smaller-capitalization stocks. In absolute terms, this asset category can be seen as a riskier one in which to invest than larger businesses: Typically, a larger company has a broader range of business lines, a wider range of customers on whom to rely for sales and profits, greater access to capital, and a longer operating history. All these factors tend to reduce the perceived risk of investment in the eyes of money managers and others. But during the 5-year period between 2003 and 2007, bond markets compressed to an irrational degree and the small-cap stocks outperformed, beating blue-chips by 32%, or nearly 4% a year. Small-stock fund managers basked in the limelight and rejoiced in their returns, even as pundits predicted stubbornly, year after year, that this year would mark a return to life on the part of large-cap stocks.

By June 2007, small-cap stocks had celebrated a prolonged period of easy credit and outperformance, and the writing was on the wall. Investors seemed to remember the fundamental truth that in tougher times bankers are still going to be likely to trip over themselves to lend money to bulwarks of the economy like General Electric. But the same can’t be said of lenders’ attitudes to smaller stocks, such as a specialist retailer. Sure enough, lenders’ fears that deteriorating subprime home loans would cause a slump in the corporate bond market spilled over into the stock market. Suddenly, lenders and investors alike decided they wanted to be compensated for the extra degree of risk associated with those asset classes and categories that tend to fall higher on the risk curve, from junk bonds to smaller-cap stocks. Market readjustments such as this are never easy and painless, but for small-cap stocks, the pain was worse: While the S&P 100 index of the largest U.S. stocks slid 2.5% between June and July 2007, the Russell 2000 Index (a broad measure of small-cap stock performance) slumped 6.9%.

Afraid of being caught on the wrong side of a flood of new liquidity, or of being left high and dry when liquidity evaporates overnight? You’re not alone. So common are these fears—and the periods of ebullience and optimism that also characterize financial markets—you need to add investor psychology and market sentiment indicators to the list of factors to incorporate into your investment process, as I explain in the next chapter.