Horsepower vs. Torque
February 14, 2012
If you’re a leveraged investor forced to sell into a falling market, your counterparty needs to be someone in a different position. Other leveraged investors may well be feeling the same pain that you are. In this kind of situation, the ideal source of liquidity might be a long-term investor with no leverage and a contrarian investment philosophy. (Think of Warren Buffett contemplating the purchase of the Long Term Capital Management portfolio.) Contrarian investors are hard-wired to buy when everyone else is selling, so they are obvious sources of liquidity. Momentum investors are liquidity sinks.
Leverage is the enemy of liquidity, since high leverage forces investors into short-term thinking and momentum-driven behavior. High leverage means that you have weak nerves and no staying power – you’re worried about margin calls and other surprises that would force you to transact. And high leverage can spawn momentum trading, because when your position is moving against you, the margin call forces you to sell into a falling market or buy into a rising market.
These facts about liquidity have important consequences for both investors and regulators. Since contrarian thinking is an essential source of liquidity, a herd mentality among investors is a prominent threat to liquidity. The investment business has evolved toward a perilous concentration of power. Never before have so few decided so much on behalf of so many, and those few think increasingly alike. Large institutional investors constantly compare themselves with other members of their peer group (such as large corporate defined-benefit pension plans or small university endowments), which encourages mimicry and group-think. The best antidote is to ask: How am I different from the other members of my peer group, so that I might buy what they’re selling and sell what they’re buying?
And these facts about liquidity have consequences for regulators. The Volcker Rule, for example, has the potential to reduce torque, while the Tobin tax is aimed more directly at reducing RPMs. The Volcker Rule is an understandable response to various proprietary trading abuses, but the fact is that proprietary trading desks have been an important source of medium-term capital that is willing to withstand a certain degree of price volatility. The Volcker Rule thus needs to be crafted so as not to prevent broker/dealers from committing capital to create liquidity for customers. As for the Tobin tax, such a tax is explicitly designed to slow down the market engine, an approach that its critics describe as “throwing sand into the wheels of commerce.” The question is whether that is automatically a bad thing. Again, any such tax would have to be designed to avoid unintended consequences that would be harmful to ordinary investors.
However, some of the anti-tax rhetoric is based on the conviction that anything that slows markets damages liquidity. That conviction confuses liquidity with speed. If we want markets with more horsepower, what we need is not higher RPMs, but more torque.
Robert Jaeger is senior investment strategist, BNY Mellon Investment Strategy and Solutions Group (ISSG), which is part of The Bank of New York Mellon, a principal banking subsidiary of BNY Mellon.
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