The Liquidity Premium

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  • on January 27th, 2011

I generally discuss equities here because that is my area of focus.  But this article from David Kotok had enough instruction that I considered it a worthy inclusion here.  His bullish thesis is woven through the piece, but my focus here is on his discussion of the differing structure between muni bonds and stocks.

“In a dealer market the inventory can be marked up or down without any trading. The manager of this inventory in each firm determines the price he wants to use to buy or sell and can change it at any time. Therefore, when there is selling pressure the dealers just mark down their bids. Alternatively, they refuse to bid by saying “pass.” The reverse is true when prices are rising sharply.”

Leaving aside his arguments in the rest of the article, this is a key distinction and one that sounds familiar from our experience with the May 6 Flash Crash.  It was the withdrawal of committed dealers that exacerbated that move, and caused Main St. to question the integrity of the system.  Widely traded markets, however, are able to more quickly attract liquidity, resulting in a much more fleeting arbitrage opportunity.

The merits of a trade or investment are one thing.  But don’t forget its liquidity.  While someone with confidence and an ability to hold long-term may sense an opportunity in munis, the trader must remember the market structure.  The fact that this can happen means it needs to be sized as though it will.  Be it small cap stocks, real estate, private equity, or investing in a business…less liquidity dictates smaller position size and longer expected hold time.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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