The Illusion of Liquidity

If there were any doubt that speculative activity is back, this should settle it: The major online brokerages, including Ameritrade (Nasdaq: AMTD  ) , Motley Fool Stock Advisor selection Charles Schwab (NYSE: SCH  ) , E*Trade (NYSE: ET  ) , and Toronto-Dominion Bank's (NYSE: TD  ) Waterhouse have seen an explosion in daily trading volume.

Whereas Ameritrade's daily trade volume in 2002 rarely exceeded 140,000, this past week it announced that it had set a record on Jan. 20, with 326,000 trades, and averaged 254,000 for the month. Trading volumes for options similarly shattered all-time highs this past month, more than 60% higher year over year. Options volume is heavily weighted toward calls, with puts trading at substantially greater time premium. Translation: People think that the markets will continue to climb. Margin balances, predictably, are skyrocketing.

This past weekend, Barron's excerpted from Baupost Group principal Seth Klarman's annual letter to shareholders. Klarman is perhaps best known for his now-sadly-out-of-print book Margin of Safety and is an extremely successful value investor. In his letter to shareholders, Klarman wonders just "what today's speculators could possibly be thinking" buying stocks, bonds, real estate, just about any asset class at present prices.

But the key to Klarman's discomfit comes not in spite of the horrible losses of the last few years, but because of them. A friend of mine described it this way: There really has been cash on the sidelines in the last few years, and we're in the midst of a rush to deploy it. People have waited out the trough, and are now trying to ride the wave upwards. They don't want to miss out.

And you know what? He's right. That's exactly what's going on. People fully expect that there will be people tomorrow who will buy the same overpriced securities they themselves bought today. Valuation? Yeah, like it matters. Things are going up. That's what matters. This puts into perspective the anger that our warnings on companies such as Sirius Satellite Radio (Nasdaq: SIRI  ) , Internet Capital Group (Nasdaq: ICGE  ) , and Ivanhoe Energy (Nasdaq: IVAN  ) have engendered in stakeholders.

When the most important thing about an investment is whether it goes up tomorrow, then someone pointing out weaknesses in the overall investment thesis constitutes a direct threat. When momentum is the driver, such roadblocks are deadly, because investment success is predicated on someone being willing to buy it at a higher price, at any point. That such opinions have no bearing at all on the business is beside the point. A momentum stock must maintain its momentum at all costs.

No speculator left behind
One of the main reasons that people feel more confident this time around is that they have learned a lesson from 2000: If they had only been able to cut their losses during the last slide, they'd have been just fine. There are many ways people are doing this, but one of the most popular is a tool called the "stop-loss." The theory is that if you place an automatic sell, say, 8% below your purchase price, your stock will be sold before you can get badly, badly hurt. It's a game of letting your winners run and cutting your losses, and it's nothing new -- sort of like idiot insurance.

I certainly recall a few people for whom the stop-loss got them out of the Junipers (Nasdaq: JNPR  ) of the world when they were really expensive. In a market where billions of shares are traded each day, there's not much reason why stop-losses wouldn't work. Still, of the people who employed heavy use of stop-losses in the last meltdown, I don't know of many who became filthy stinking rich as a result. But each of us knows plenty of folks who didn't use any stop-losses and were shellacked.

The way I see it, this is a spurious correlation. You don't get hammered in the market for want of a stop-loss; you get hammered buying overpriced crap in the first place. But this is exactly what's happening today. We're in 1987 all over again, and everyone's holding "portfolio insurance." Buy whatever you want. Have fun. Just remember to be the first to get out.

And that's the problem with what's taking place. Unlike 1999, the warnings of spectacular overvalue are legion, and people seem to be paying attention and speculating anyway. Everyone, it seems, will play the game thinking that he can get out before the collapse. Everyone has a stop-loss in place and is ready to sell the moment stocks start "acting bad."

And everyone cannot be right. But it seems that people have once again adjusted to prepare for the previous menace, the thing that burned 'em the last time around. Trouble is, it won't be the same thing that burns 'em the next time. It never is.

Whom God would destroy...
We've now seen almost a year of consistent rises in all of the big indexes with no drop of more than 5% in that time. During this period, the non-believing market "players" have kept their stop-losses in place, just in case they need to rush for the exits. All of this presumes that in each case there will be someone willing to buy at the price of the stop-loss trigger. But here's the thing about the stock market: Even though individuals can mostly count on liquidity, the overall market cannot. Everyone cannot depart at the same time -- there have to be buyers.

At some point, the stock market will decline by more than 10%. It's as guaranteed as the rising of the sun. When this happens, with extremely speculative stocks, the first of the stop-losses will be triggered, creating more selling pressure, dropping the price lower, triggering even more stop-loss sales. Where does such a thing stop? Just as we see short-selling activity at multi-year lows -- from a fundamental perspective, at a time when there are cases of overvalue aplenty -- as people don't want to get hit by the momentum bus, one would have to assume that people won't be that excited about piling into a cratering momentum stock on the way down.

Will this happen? Man, I don't know. What I do know is that speculative activity has spiked, that confidence levels are extremely high, that there are clearly millions of people involved in the stock market who are counting on continued momentum, but that many of these are hedged on the downside should that momentum ease.

...would he first make confident
But what happens if, rather than an easing, there's a disorderly rush for the exits? Some will get out unscathed, but not most people -- they can't unless someone is stepping up to buy. And if momentum, not fundamentals, were the reason for most people's buying a stock in the first place, then why in the world would one expect enough people to step up to the plate and buy when the momentum evaporates?

This scenario, by the way, has its own precedent. In 1987, many institutional investors utilized "portfolio insurance" techniques to try to limit their downside risk. What they found, rather than being stopped out for small losses during a bloodbath, was that they had entire positions sold at whatever price was available on the market, some being locked in at losses of 35% or more in a single day over their entire portfolios. It may not happen again, but the conceit of traders that they're faster and more nimble than everyone else is simply too widespread to suggest that such an outcome isn't likely under conditions awfully similar to what we have today.

There is no such thing as a bulletproof model. People who ignore fundamentals of the companies they hold are playing a dangerous game. Because sometimes the greater fool just happens to be you.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann wonders if the low-carb craze means that "sliced bread" is not as great as we thought. Bill has no beneficial interest of any kind in any of the companies mentioned in this article. Please check his profile for current holdings. The Motley Fool is investors writing for investors.


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