One of the disconcerting things about markets in 2018 is the proliferation of “this doesn’t matter until it does” stories.
Things that “don’t matter until they do” are dangerous because people tend to ignore them until it’s too late.
That’s the quandary inherent in things that “don’t matter until they do” – implicit in that characterization is the idea that it makes no sense to worry about them ahead of time because in many cases, they either aren’t tradable or if they are, trading them entails burning premium until something snaps, which is a nice way of saying that trading them equates to underperformance in all but the most acute market environments.
One of those “this doesn’t matter until it does” stories is a gradual erosion of liquidity and market depth. For most investors, “liquidity” and “market depth” are nebulous concepts and by virtue of being amorphous, don’t garner much attention.
We’ve documented deteriorating liquidity on all manner of occasions in these pages and, as is customary, we try to do so in a way that’s some semblance of honest – where that means not pretending that the world is going to end just because, for instance, top-of-book depth has deteriorated.
Contrary to what you might have read from the doomsday crowd, the inability to transact in size during a flash crash doesn’t mean we’re all going to be living out Cormac McCarthy’s The Road within 12 hours.
Anyway, it’s worth doing a quick update on market depth for U.S. equity futures in light of a piece out Friday from JPMorgan’s Nikolaos Panigirtzoglou, who notes that last month’s selloff has again “raised questions about liquidity.”
As usual, Panigirtzoglou utilizes one of his favorite liquidity indicators, a volume-based measure of volatility in futures contracts called the Hui-Heubel liquidity ratio.
“Figure 9 shows that there has been a significant deterioration in market breadth of global equity markets over the past month similar to the deterioration seen earlier this year during February correction, but so far less than the deterioration we had seen during August 2015 or January 2016”, Panigirtzoglou writes, adding that “we get a similar message if we look at an alternative market depth metric for S&P 500 futures.”
The chart header on Figure 10 spells things out pretty nicely. It’s just the average number of contracts at the tightest bid/ask for E-minis – clearly, market depth plunged in February and hasn’t recovered since.
“Not only does Figure 10 show that market depth for S&P500 futures contracts deteriorated in October but also that it has been much lower this year on average relative to either last year or previous years,” JPMorgan says, describing the visual in the right pane.
As ever, less market depth means equities are more vulnerable although, on the bright side, JPMorgan does not observe much in the way of similar trends in other assets (i.e., in bonds or commodities).
We always close these types of posts with the same quote from Panigirtzoglou’s colleague at JPMorgan, Marko Kolanovic, and we see no compelling reason to break with precedent here. Here’s what Marko wrote earlier this year about the February selloff:
We have noted in the past that a combination of computerized sellers, and computerized market makers poses a threat to equity price stability. As volatility increases, systematic investors have to sell, and at the same time market depth as provided by electronic market makers quickly disappears. For instance, S&P 500 futures market depth dropped over 90% during the February selloff. What is the reason for such a dramatic drop in liquidity? The most important driver is likely the increase of volatility (e.g. VIX), given that many market making algos (as well as business models) were calibrated during the years of low volatility. As these programs don’t have an obligation to make markets and are optimized for profits, they likely adjust quotes and reduce size in order to maximize their own Sharpe ratio.