Editor's note: Today and tomorrow, we're sharing more from Dan Ferris in a series adapted from his February 25, 2022 Stansberry Digest. In this essay, Dan explains the importance of useful insights as an investor... and what one of the most talked about financial terms actually means for you and your money.
Unfortunately, much of the mainstream financial media's output is little more than word salad...
And most talking heads using words like risk and liquidity have no insights to share about what those words represent in reality.
The Nobel Prize-winning physicist Richard Feynman felt this way about ideas like "friction" and "gravity"...
For example, if a child asks why their sneakers wear out, the answer is not "because of friction." A real answer – a Feynman answer – might be something like... "Your sneakers wear out because with every step you take, little pieces of concrete sticking up from the sidewalk rip little pieces of shoe rubber off your shoe. Over time, your shoe has less and less rubber on it, so it wears down."
To say that markets move based on liquidity is as useless as telling a child that things move because of "energy."
As an investor, you need useful insights – not another useless word to throw around at cocktail parties.
So let's start by providing a useful definition of liquidity...
Then, we'll talk about why it's more important than you might realize today – even for some of the biggest, most successful stocks in the market...
The meaning of liquidity for most folks is the ability to buy and sell assets very quickly, without worrying about big price movements between the moment you place your order and the moment it is executed... or virtually instantaneous execution for market orders.
If you trade stocks, bonds, options, futures, or other securities or derivatives for short-term profits, you're doing so under the assumption that you'll easily be able to buy and sell them without moving the price. That's what we mean by a liquid market.
For most folks, liquidity is like the air they breathe... They don't think about it unless it's suddenly not there. It's an ever-present bid for whatever you want to sell and the ever-present offer of whatever you want to buy.
It's important to consider liquidity risk before you invest. For example, when my colleague Mike Barrett and I make recommendations to our Extreme Value subscribers, we stay away from stocks of companies under about $500 million in market cap... though we've made a few exceptions over the years. We also prefer stocks that trade several million dollars of volume per day, on average.
We do this because the smaller a company's market cap is (and the fewer shares available to trade), the more likely our subscribers are to move the stock price substantially when we recommend it. The act of trying to buy or sell at a certain price can change the price of the stock.
When that happens, it creates problems...
Less liquidity raises the risk that you'll wind up selling at a price far below the recommended sell price... or buying in at a higher price than you should.
In brief, liquidity tends to fall with market cap and trading volumes. But I don't mean to imply that liquidity risk is only present for small-cap stocks... Not at all.
Liquidity risk is higher than you might guess for mega-cap stocks...
In my talk during the 2017 Stansberry Conference in Las Vegas, I warned that liquidity risk can and does happen to the biggest-cap stocks of the greatest businesses in existence. I included Meta Platforms (META), then called Facebook, in that list.
Since then, the stock has sustained large one-day losses three times, as shown in the table below...
When a stock instantly plummets with no trades at many prices in between, it's the market saying... "There were no bids at all those price levels between the last trade price and the one immediately following."
Meta's market cap was $630 billion the day before it lost 19% of its value ($121 billion) on July 26, 2018... It traded between 10 million and 30 million shares per day in the weeks prior to that.
It was as highly liquid as you could ever want. Nobody was thinking about liquidity risk with Meta... Nobody thought it could lose $121 billion in market cap until it did.
Then, on February 3, 2022, Meta Platforms lost $252 billion of market cap in one day ‒ now the largest one-day market-cap loss in history. The two-day intraday price chart below is dramatic...
The stock fell almost instantly in after-hours trading on February 2... It opened down 25% the next day, February 3.
Whether you trade after hours or not, the loss was fast... too fast. You couldn't have escaped it.
In effect, there was zero liquidity in the area where that loss occurred... meaning that, during after-hours trading on February 2 and all day long on February 3, it was impossible to execute a transaction at a price near the February 2 regular-session closing price recorded at 4 p.m. Eastern time.
Imagine holding a stock that's trading around $322 a share... and in the next instant, it's trading at $246. There were zero bids – zero liquidity – at all the hundreds of price levels in between those two prices...
That is what liquidity risk looks like in a mega-cap stock...
It's as if you were rowing a boat across a smooth lake, and suddenly the water drained away and left you sitting on the lake bottom with fish flopping all around you.
Perhaps you're thinking that Meta's fundamentals were suddenly poorer than expected, and the market reacted more violently than anyone expected... So maybe you think that I'm wrong to label such an event as an example of liquidity risk.
But it doesn't matter why liquidity suddenly evaporates. My point is that the assumption that it won't evaporate instantly is a flawed one.
Don't be surprised if you see more such events – not fewer.
Editor's note: Dan says we're on the verge of a rare market cycle that's 50 years in the making. It could shake up nearly every asset you own... Yet most investors will be entirely unprepared for it. That's why Dan recently sat down with an industry legend to explain how this economic setup could unfold... and how you could potentially earn extraordinary gains. If you missed this event, get the details here.
The most recent bear market could change the way you invest for years to come. A declining-rate environment is no longer ruling the markets... And we're likely entering a more difficult period of greater risk. Your best ideas might now be your worst... Read more here.
"Too many investors nowadays still don't understand that they were faking it in the bull market," Dan writes. In order to protect and grow your wealth in tough market environments, investors need to have real knowledge of recognizing and controlling risk – not just enthusiasm and narrative. Read more here: It's Time to Hang Up Your Chauffer's Hat.