The Impact of Liquidity Feedback Loops
In my last blog, I mentioned that one of the big factors in the GameStop episode was increased liquidity from the Federal Reserve. Liquidity injections are nothing new, but as we said when the Fed first issued its liquidity, it was not the proverbial bazooka but a howitzer. Excess Fed liquidity over recent decades has typically found its way into the asset market more so than into the hands of those most impacted by the economic damage. This is because generally these injections serve to shore up the banking system and keep investor confidence high. The Fed generally relies on Congress to effect a fiscal stimulus to get money directly into the hands of consumers, as the ability of the Fed is impotent to do such. The result of this cannot be overstated, as we saw how quickly markets rebounded after bottoming out in March 2020 while many small businesses in the ground zero part of the economy (e.g., restaurants, hotels) continued to struggle.
Standard economics dictates that the price of financial assets is efficient, meaning that there is a strong level of price discovery as many investors have access to the same pool of information, and are able to quickly arbitrage away any mispricings that may exist. As a result, the market process is assumed inevitably to drive assets to their fair values. However, reality says that such a construct does not hold as often as it should for two primary reasons:
- behavioral biases and emotions (e.g., greed and fear), and
- liquidity feedback loops.
Both of these factors were quite relevant to the GameStop short squeeze, though the former is often touted for how asset prices get pushed up or down beyond a reasonable fair value and the latter is generally not.
Within any asset class*, liquidity feedback loops lead to buying pressure that pushes up prices, which accomplishes two things:
- momentum investors get attracted to the asset, and
- the risk-reward ratio of the asset class looks more favorable than its real value
Both of these effects beget further inflows, thus leading to even more buying, etc... Notably this happens with asset managers, who often (but not exclusively) buy securities owing not to fundamental thesis but rather not wanting to be left behind by the herd.
Of course, liquidity feedback loops also lead to pushing prices down. When poorly performing asset classes or securities are shunned by momentum investors as well as demonstrate poorer risk-reward characteristics than should be the case, it leads to further investor redemptions and eventual forced selling that causes further price declines, and so on and so forth.
As we saw on a micro level with GameStop and on a more macro level in 2000 with internet stocks, liquidity loops can go on for many years and are important contributors (if not the most important contributors) to asset-class bubbles and busts and secular lows that lead to fire sales prices.
We would be hard-pressed to say that the market over the last few years has been, in general, a bubble, but there certainly have been speculative elements on a micro level. Beyond what we saw recently in GameStop, consider WeWork, which saw a peak valuation of a mind-boggling $47 billion for merely renting commercial real estate and subleasing it into smaller coworking spaces. While the company’s current valuation is undetermined, some estimates have the markdowns at 90%-95%, (i.e., a current value in the range of $2.3-$4.7 billion), with the company having demonstrated little but an accumulation of operating losses and billions of dollars of long-term lease liabilities.
So why was WeWork’s valuation so high? Not dissimilar from the macro bubble we saw in the late 1990s, a tantalizing narrative of growth RESULTING from a “new paradigm” in a “new economy” caused many funds to pile into the company, most notably the renowned Vision Fund. This large name begat further inflows, driving the valuation of WeWork much higher. The liquidity feedback loop continued as even more funds jumped in to try and make a quick profit on the “new paradigm.”
Liquidity feedback loops are present in private markets, like with WeWork, and in public markets. In public markets, fund managers who have outperformed often receive large inflows from investors chasing performance, and because they typically are constrained on how much cash they may hold, they will put the money to work somewhere, regardless of their views on the valuation of the stocks in their universe. In fact, it is quite possible the fund managers think the stocks are overvalued and would prefer not to buy the stocks, and yet they still buy them. This is not only because of the aforementioned cash constraints but also because if the fund managers elect to hold cash hoping for a superior buying opportunity, they risk potentially career-destroying levels of underperformance if the stocks continue to rise while they sit in cash.
In discussing the GameStop phenomenon, note how little all the buying and selling and the resulting volatility has anything at all to do with fundamentals and the so-called rational price discovery touted by the efficient market hypothesis.
This includes major secular bull and bear markets, not just shorter-term timeframes. Again, liquidity feedback loops can unfold quickly, as we see in bubbles and crashes like GameStop, or it can unfold slowly in long, drawn out bull and bear markets.
So, a market composed of intelligent and well-informed investors does not preclude these inefficiencies. The ones who most notably suffer for long bouts of time as a result of these liquidity feedback loops are value managers because while their theses may be right in the very long run, in the short run, medium run, and even sometimes in the long run, liquidity feedback loops tend to shun “cheap” stocks because they typically seek the securities most likely to give instant gratification. These Growth episodes seem to happen every 20 years or so, as evidenced by the recent Growth run, the late 1990s tech bubble, the “Nifty Fifty” during the late 1960s-1970s. This does not mean we are calling an end to the Growth bull market right now, but it does mean that over the next 7-10 years, Value stocks are highly likely to outperform their Growth counterparts. Recall that we have mentioned that the greatest predictor of longer-term returns is the starting valuations, though typically the path to get there is uncertain.
In summary, it is important to understand that market inefficiency is often structural and behavioral, not informational, as a result of liquidity feedback loops. Because many investors do not contemplate the liquidity aspect of inefficiency as much as they contemplate the informational aspect of inefficiency, those investors attempt to invest on the basis that market inefficiency results from information discrepancies (e.g., the market is missing the story on a “cheap” stock, so the stock should be bought) rather than liquidity feedback loops. So, said investors spend much time and resources coming up with “better information” than the next investor.
* An “asset class” can refer to any broad category of securities such as “equities,” “high yield bonds,” or “venture capital” or within a broad category, it could refer to categories of securities segmented by areas such as geography, style, sector, market capitalization, or, as has been very popular of late, factor.
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