Fenil's Library

Devendra Nevgi. Mumbai

Many a times, retail investors consider a host of factors before investing into the individual stocks or markets in general. Some of the major ones are the historical financials, company prospects, group to which the company belongs, past dividend record, the P/E ratio and so on.

A very important factor, “liquidity” is, in often ignored. Many investors might be surprised to know that the epicentre of the recent global financial crisis was liquidity: Initially the excess of it, followed by the scarcity of it.

What is liquidity? Why is it so vital to the economy and markets in general?

Liquidity often has different interpretations in different contexts. There are three
concepts in relation to liquidity:

* Monetary liquidity, which refers to the general monetary and credit conditions in the economy.

* Markets liquidity, determined by how easily financial assets (such as stocks) can be bought or sold without significantly impacting their price.

* Balance-sheet liquidity or funding liquidity, which is the ability of a corporate or bank to raise money at very short notice, either via availing credit or selling short-term assets that it holds on its balance sheet.

From an investment perspective, we will focus only on the monetary and markets liquidity.

Monetary liquidity includes the price of money (interest rates) as well as quantity and availability of money in the system, to the borrowers. The RBI, by its policies, influences the price and quantity of money available in the economy. This kind of liquidity is reflected in the monetary aggregates such as money supply (M3) and banks lending figures. Both of these figures are available on the RBI’s website.

A thumb rule to determine how much monetary liquidity is good for an economy is that money supply should grow at more or less the same rate as the real GDP growth rate plus the inflation (nominal GDP). If money supply is higher, it might lead to higher inflation and rise in asset values (such as stocks, commodities, real estate etc) in the country. If it is lower, it might choke growth and be deflationary.

Appropriate liquidity levels are necessary for sustained economic growth. In recent times, many central banks have been pumping money into the system to re-inflate their economies. Such liquidity often “spills over” to other countries, and creates demand for the assets in those countries. Many a times, such liquidity disappears at a very short notice too.

Market liquidity refers to the ability of the market (such as a stock market) or the financial system to absorb large buy or sell orders without significantly impacting the price levels. The speed at which a transaction can be executed without much movement (impact cost) in prices, the difference between buying and selling quotes at same time (breadth or bid/ ask spreads), how fast the prices return (resilience) to their fundamental levels after a large order is executed are all indicators of market liquidity.

Higher the market liquidity, better for the markets and vice versa, since it facilitates accurate price discovery of traded asset classes such as stocks.
Monetary liquidity and market liquidity are often inter-linked and have reasonable positive influence on asset prices, such as stocks or real estate, through the “risk appetite” and “confidence” channels.

Global monetary liquidity (FII inflows) has been an important driver of the Indian stock markets in recent years, both on the way up and on the way down. This is evident in the last few months, where Nifty levels have almost moved in tandem with the higher liquidity, thus creating higher volumes.

For investors, market liquidity remains a crucial input for buying stocks. Historical average volumes per day and the bid/ ask spreads are indicators of the same. Stocks with higher volumes and lower bid/ ask spreads should be preferred, as the influence of speculators and the impact of large orders on the stock is relatively lower.
Liquid stocks don’t rally on a large buy order, nor crash after that buy order is fulfilled, or if a large sell order is placed. Illiquid stocks are a speculator’s paradise and investor’s nightmare, and should be avoided by risk-averse investors, since they are susceptible to price manipulation.

Lower market liquidity increases the risks in stocks and distorts its factual realisable value.

Monetary liquidity can be easily tracked on the web on the RBI website and through periodical reports. And in general, the higher the liquidity, the better for risky assets, and vice versa. But there is a caveat — a sustained excess monetary liquidity can lead to asset price bubbles, wherein asset prices substantially deviate from their intrinsic values. And it does cause lot of pain when such bubbles ultimately burst.

To conclude

Investors should also take into account the market liquidity before buying into an individual stock.

This will prevent a situation of their being saddled with illiquid stocks in falling markets, which they can never sell at the right price. Illiquidity weakens the fair price discovery process.