Liquidity Signals

Market liquidity conditions and their changes are major drivers of equity price development. Their influences can range from impacting financial markets over long time periods to driving short-term moves. In this post, I explore how we might generate systematic investing and trading ideas from a variety of specific liquidity conditions.

Some Examples of Influential Liquidity Conditions

For instance, the FED’s “easy money” policy is widely thought to have been a major tailwind for the 2009 to 2020 generational bull market, where cheaply-available capital has triggered passive indexing and momentum flows to generate a positive liquidity feedback loop, boosting equity prices. Low interest rates force market participants to go out further and further on the risk curve to meet their return requirements.
Fast liquidity cascades can drive prices over the course of several days or weeks. For example, when a catalyst increases selling pressure, margin requirements force market participants to raise liquidity during rapidly deteriorating prices, as buyers in all asset classes suddenly vanish. This played out in the unwind of March 2020.
Liquidity flows over even shorter time horizons can play a large role in today’s market as well, due to the ever-increasing amount of options trading. I have written several articles on the impact of option market makers on the flow of liquidity in and out of equities. The key lies in pinpointing crucial turning points, where the direction of dealer hedging flows can shift suddenly.

Awareness of current liquidity conditions can be a powerful edge for active market participants, as these flows and their pivot points are often predictable.

Changing Market Behavior?

Over the past few years, we’ve witnessed a growing tendency for extended, volatile market moves. These are driven by increased liquidity feedback loops taking place over all time horizons, regularly leading to large price swings in both directions.

“These new forces will lead to bouts of volatility suppression and explosion, as market participants and hedgers migrate from convergent to divergent trades in increasingly illiquid markets.” Corey Hoffstein, Newfound Research

Valuable signals (as in, immediate warning signs or strong headwinds / tailwinds causing reliable trends) can be revealed by analyzing the flow of market liquidity.

The Liquidity Cycle

Looking at the big picture, Corey Hoffstein of Newfound Research illustrates a pro-cyclical loop in his recent paper “Liquidity Cascades” (well worth a concentrated read or listen in the podcast version). Each element has become a growing factor over time, and in concert, they create a widening amplitude in stock prices: long rallies are interspersed with deep crashes.

Source: Liquidity Cascades by Corey Hoffstein

Looking closely we can see the same mechanism play out in fractals within the separate factors over shorter time horizons. Individual market drivers become very influential, acting as support for rising prices initially, until the feedback loop becomes unsustainable and prices collapse.

To gain an understanding of the nature of these flows and to spot the likely tipping points, I split my analysis into different time-frame buckets. Let’s boil it down to a variety of actionable ideas, that could lead to an edge in timing market swings of different durations.

Lessons for Buy-and-Hold Portfolios

Liquidity-driven markets, in the current low-interest-rate environment, imply that the traditional 60/40 portfolio likely won’t perform adequately in the future. Stocks face increased crash risk, as liquidity cycles cause extreme market swings, while low (or negative) bond yields currently equate to “return-free” risk rather than a safe source of income.

Two excellent papers present the construction of a modern “All-Weather” portfolio. Christopher Cole (volatility expert at Artemis Capital Management) and Corey Hoffstein both dissect the market environment into distinct regimes, assembling a puzzle of assets and strategies that are most likely to survive and thrive over the very long run.

Source: Allegory of the Hawk and the Serpent, the DRAGON PORTFOLIO by Christopher Cole

Source: Liquidity Cascades, The DAEDALEAN PORTFOLIO by Corey Hoffstein

These two portfolios, while quite distinct from one another in their details, share a common feature in that they allocate a large part of their capital to specific alternative strategies.

Both use active trend-following and long volatility strategies as core components to enhance their diversification through traditional asset allocation.

For individual investors, such alternative strategies pose a practical problem: to run a complex portfolio might require specialized money managers. Such expertise is only available for high-net-worth individuals and comes with large fees, which might eat up much of the expected outperformance.

Tactical Long-Term Investing

For my own core portfolio, I have taken up the idea of investing according to distinct market regimes and, based on this, developed the tactical “Meta Strategy”. The strategy simplifies my implementation greatly by using just a few ETFs at a time, relying on the postulate that market regimes (or liquidity environments) tend to stick around for a while and that current momentum is likely to hold. Actively investing like this concentrates only on assets and strategies that are more likely to be effective in the current market environment. (Read all the details in the free Meta Strategy eBook.)

Apart from several measures that judge fundamental liquidity conditions and their potential to impose headwinds or tailwinds on the market, the strategy relies on volatility-based signals to highlight periods of increased risk of a downward spiral.

Market stress and spiking volatility cause rapidly declining liquidity. The VIX can be used as a proxy for market liquidity conditions.

Watching the point at which options dealers’ gamma exposure flips negative (the zero gamma level) gives a first indication of a possible volatility trigger. A central role is then given to the shape of the VIX futures term structure: a strong, “unnatural” inversion of the term structure signifies a likely liquidity pivot point.

When, at this point, independent market participants start to increasingly sell assets in concert, then correlations rise and liquidity is sucked out of the market in a downward cascade. This can be the start of a massive leverage unwind:
Market makers become short sellers; increasing margin requirements force sales; volatility-targeting strategies sell off risk assets; structured products are unwound; and so on… until the FED steps in with its liquidity backstop (which has become the “new normal” in recent years) and restarts the cycle anew.

These volatility signals can be used to switch a tactical portfolio from risky to safe assets early in a new cycle, while simultaneously serving as a useful regime filter for guiding actions across shorter time frames.

On the other hand, in the beginning of a positive liquidity cycle, a market regime-based strategy can take advantage of the anticipated FED backstop to use increased equity leverage, or piggyback on passive liquidity flows by taking advantage of the resulting strong momentum effects (e.g. by buying mega-cap stocks or momentum strategies).

Short- to Medium-Term Cycles

The influence of the options market on liquidity flows is growing steadily, to the point where options are becoming the tail wagging the dog. Case studies, that highlight specific tipping points in market liquidity, are a valuable tool for finding similarities to current conditions, offering a starting point for further analysis to build systematic models. You can find a list of previous articles dealing with this complex theme — all of which contain additional insights based on a close study of distinct market events — at the end of this post.

“Approaches may potentially be enhanced through the explicit modeling of dealer and structural hedger positions, helping allocators identify potential “hotspots” of liquidity slippage where hedgers tilt from aggregate liquidity providers to liquidity takers.” Corey Hoffstein, Newfound Research

End-of-Year Patterns
Seasonality is quite real and I want to specifically look into tendencies toward the end of the year (e.g. the classic Santa Claus rally and the January effect) to either play out quite predictably or fail spectacularly:

1. December traditionally (through annual portfolio hedges) holds the highest put option open interest of the year. Rising stock prices and falling volatility in the weeks before December expiration create a positive feedback loop, as option dealers continually decrease their hedging, pulling the market up like a magnet to create a rally, which often carries over well into the next year.

2. But, if price breaks down below key levels (Zero Gamma and VIX futures term structure inversion), the opposite effect may take place, with market makers shorting equity futures (because they have to increase the hedge on their short put positions as these move toward their strike prices), causing volatility to spike. This tends to accelerate the drop, cascading into other areas of the market, and it’s unclear where it will stop and find a bottom.
Option expiration dates are a good place to start looking for that transition point, as dealers unwind a lot of their hedges here (e.g. December 2018).

Black or white: comparing the year-end of 2018 with that of 2019

Margin Requirements
It is a tell-tale sign when brokers increase their margin requirements, as this exerts downward pressure on prices, leading to reliable declines. Most of the time these raises coincide with periods of market stress and exacerbate the downward spiral.

In February to March 2020 equity futures margin requirements jumped by +100% within one month — an increasingly strong sign that the cascade would likely be an extreme one.

From a detailed case study by Disciplined Systematic Global Macro Views.

Sometimes, however, brokers raise margin requirements in anticipation of a potentially volatile event. This leads to a very interesting and predictable cycle.

For example, in October 2020, anticipating volatility around the US election, Interactive Brokers increased margin requirements up to 35% from normal levels into October 23rd — a process they communicated well in advance. This tightened the screw on liquidity, likely increasing the market’s vulnerability in the week before the US election, when demand for hedges rose. The market dropped before the event amid an uncommonly large volatility spike.

The subsequent short unwind, as hedges were reduced when volatility deflated in the week after the election (triggering Gamma, Vanna, and Charm liquidity flows), found additional support from margin requirements relaxing: a 400+ point rally in the S&P 500 ensued.

For a current play-by-play on option-based, short-term liquidity flows, a great resource is Cem Carsans Twitter feed (@jam_croissant).
The specialists at spotgamma.com and squeezemetrics.com provide additional information and are excellent sources for current data. (Some of it is subscription based.)