Let’s Talk about Liquidity

An interesting debate in the world of finance is what drives markets? Some say fundamentals and some say liquidity.

This is a relatively advanced topic, but let’s dive in. Fundamentals are the characteristics of the securities within the markets. These characteristics for example could be PE ratios, which can be used to suggest valuation relative to other markets and historical precedent. The idea is that if stocks are cheap, then they will go up and vice versa. On the other hand of the debate is liquidity. Liquidity is like the Brita filter in your kitchen and everyone’s cups are different markets. If the Brita filter has water in it, then markets can rise.

The tough question for me has been defining and quantifying liquidity beyond that abstract definition. The first definition you learn on liquidity is the ease at which you can get in and out of a market. Essentially, this is the idea that there is another buyer when you want to sell. If there is no next buyer, then the market price for the asset will go down to create a buyer.

The original question devolves to what causes markets to have a next buyer so that prices do not descend in search of the next buyer? Is it fundamentals or liquidity?

The question I propose to the audience is when fundamentals no longer support stock prices, how can fundamentals continue to drive markets higher? This is where I believe the debate takes a decisive turn. I believe both stances are correct under specific market conditions. If liquidity is overabundant, then I believe that liquidity overpowers fundamentals and drives markets. If liquidity is not filling everyone’s cups, then I believe fundamentals drive markets. There are nuances to this, but this is the main point.

I will now use this mental framework to discuss current market conditions. Being a fan of mean reversion and a skeptic of “this time is different,” I will use the Shiller PE ratio to discuss fundamentals. The fundamentals show us that the Shiller PE ratio is at its third highest level, which suggests third highest level of overvaluation in history. For you to believe that fundamentals drive markets you would have to believe that earnings will move up in order to compress PE ratios to normal levels. I have created a graph of S&P 500 earnings by year since 1950 in blue with a moving average line in orange. This graph is particularly interesting because it suggests that over time earnings revert to the mean. Earnings are currently at all time highs, so for fundamentals to drive markets it means you place a higher likelihood on further record earnings than the eventual reversion to the mean that has happened time and time again.

So where does liquidity come from? The main source is the central banks. Quantitative easing is a complex term, but it really just means central bank asset purchases. This means that the central bank enters the markets, buys assets, and electronically creates currency to give to the previous owner of the asset. This expands the money supply. We operate under a system called fractional reserve banking. The reserve requirement is 10%. This means that when a bank eventually receives this new liquid currency, they have the ability to lend 90% of it out. This 90% eventually finds itself in another bank that can lend out 81% of it and so on. What you need to understand is the vast power global quantitative easing has on supporting and boosting asset prices like stocks.

Below, you will find a chart of quantitative easing since 2003 by the Fed (US central bank), ECB (European Central Bank), BOJ (Bank of Japan), and China. Further below, I have created a chart of the S&P 500 that highlights, to the best of visual ability, time periods where global QE went from extremes to near zero. You can see that markets struggled in these time periods until Global QE returned.

So do fundamentals or liquidity drive markets? I think prior to 2006, I would have said fundamentals. Since 2008 though, we have entered the global quantitative easing experiment, and it is tough to dismiss the power of liquidity.