Thursday, July 26, 2007

Liquidity In Emerging Markets: An Illusion

In addition to the ready availability of money (or loans, which is the same thing), liquidity also has another meaning: the ability to readily buy or sell in sizable amounts with little price impact.

Until 2-3 years ago this was certainly not the case for emerging markets: just a few issues (perhaps 10%) traded in decent size on a daily basis and the rest traded "by appointment", more or less. While these markets are still illiquid by US standards, they have progressed. The question is, why? Have local investors jumped in, converting their bank savings into portfolio investments? This is the case in China - and definitely too much so. But in other countries something altogether different is happening.

In many emerging markets locals are passive and the most influential investors/speculators are foreign institutions (usually hedge funds), who are dealing back and forth amongst themselves, ramping up share prices almost at will. Their activity creates volume and the illusion of market liquidity, when in fact there is hardly any underneath. The locals are not active - and why should they be? They are on the sidelines enjoying the gains with whatever participation they already have.

The major question is this: when the foreigners wish to depart, who are they going to sell to? Since there aren't any really sizable domestic investors they will have to sell to one another, like in a game of musical chairs but with Ravel's Rondo played at 10x the normal speed.

It's like this: a wealthy investor identifies a small illiquid stock he thinks is underpriced and starts buying heavily. Naturally, the price goes up and he keeps calling his broker with fresh buy orders every day - after all his mark-to-market profits are bigger every day. He even starts using margin, to boost his returns. His broker, being a broker, front-runs him when he can get away with it (which is all too often) and this adds to the illusion of liquidity. "See", thinks the investor, "there are other smart guys who realize XYZ is such a good investment."

Finally, the price reaches his target point and he calls his broker with the glad news: "Bob, I'm satisfied with my big gains. Sell everything". To which the broker replies: "Happy to hear that, Charlie - but who am I gonna sell to? You are the only buyer".

Don't even think this is a hypothetical story. It happens all too often.


SimplyTim said...


Not only do I not think that this is just a hypothetical story, but I can even see it as true for the can of sardines you referred to in one of your first posts.

Blatantly simple, or brazenly and cunningly complex and hidden, an illusion is still an illusion.


Anonymous said...

This is insightful, but I don't think it's limited to emerging markets. I think you have seen the same thing in U.S. small-caps.

It's been weird to watch the behavior of small-caps via Russell 2000 and S&P 600 this year. There is definitely heavy hedge fund speculation driven by leverage in this market, fueled by an assumed private equity buy-out premium. Day after day, you could see these hedge funds leveraging up their gains into new margin on small caps.

Now, the U.S. small-cap house of cards is starting to fall. It's being driven primarily by losses in mortgage-backed and yen carry unwind, in my opinion. But it's happening before and faster than the fall you predict in emerging markets.

I'm just sitting here holding TWM (double short R2000) watching it unfold.

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