The Role Of (Il)liquidity In History’s Greatest Bear Market Rally

Liquidity — or, perhaps more to the point, a lack thereof — matters.

It matters in drawdowns and it matters in rallies. Failing to appreciate this leaves one bereft when it comes to explaining the ferocity of selloffs and the rapidity of rebounds after routs.

There are a number of ways to measure liquidity, but one thing we can say with some degree of certainty is that market depth never really recovered after the February 2018 correction which was, of course, defined by an “extinction event” in the VIX ETP complex.

“Naturally” (if that’s the right word), liquidity deteriorates in selloffs. But that simple, intuitive observation has morphed into something more pernicious in modern markets.

The relationship between volatility and liquidity “is very strong and nonlinear”, as JPMorgan’s Marko Kolanovic is fond of reminding the world. “Market depth declines exponentially with the VIX”, he reiterated in a 2019 note. “Given that an increase in volatility often results in systematic selling, this relationship is the key to understanding market fragility and tail events”.


This really is the crux of the matter when it comes to conceptualizing the “doom loop” dynamic behind most of the acute selloffs we’ve seen over the past several years.

“The supply of liquidity disappears exactly when a higher volume of futures is trying to make it through ever narrower pipes, thereby exacerbating spot moves, amplifying trends and increasing volatility all at the same time”, SocGen wrote late last month, in a volatility outlook piece for the second half. “With the VIX still above 30, order book depth on S&P 500 futures was still one-fourth of what it was in January, and given the empirical dependence on the level of the VIX, is unlikely to reach those levels unless the VIX moves below 20”. Note the reference to “empirical dependence”.

This same dynamic comes calling over and over again, and while more and more market participants are beginning to understand how it works on the way down, it’s also important to remember that a lack of market depth can also amplify upside moves.

Examples of lackluster liquidity colliding with bullish flow catalysts to create dramatic moves higher include the impact of rebalancing flows during the last week of December 2018 and the slow-motion melt-up that occurred during the first half of last year.

So, just how important was this during the recent crisis?

Answering that question could take us pretty far down the rabbit hole. Rather than go there again (regular readers have traveled down that rabbit hole with me on any number of occasions over the past four months), I thought it might be useful to highlight a few simple observations from Goldman.

In a new note, the bank spends some time modeling S&P returns based on flows, and part of that effort involves quantifying the impact of liquidity, which the bank notes “plays a role in understanding how investment flows impact price moves”.

“Flows that occur when the market is liquid have a smaller impact on price moves than flows that occur when the market is illiquid”, the bank’s John Marshall, Zach Pandl, and Rocky Fishman write, in a note dated July 2.

Referencing a flows-based model of returns, the bank says the model fit “was improved significantly by transforming each of the flow variables” using a single stock liquidity index.

Suffice to say that, as Marshall, Pandl, and Fishman go on to write, “scaling each flow variable by size tradable for a given market impact has been particularly important in recent years because of the significant and rapid decline in liquidity in Feb-2018, Dec-2018, and Mar-2020”.

Goldman looks at the recent selloff and compares the model fit both without a liquidity adjustment, and with one. Here is what the bank found (and do make sure you read the latter passage carefully):

Liquidity adjustments are important for explaining the asymmetric effects of flows on SPX returns in drawdowns vs rebounds. Using the recent drawdown as an example, the model that does not account for liquidity effects would have suggested an SPX decline of 23% from 19-Feb to 18-Mar, while the model including liquidity effects suggested a 33% decline (SPX actual decline was 29%). 

The effect was even larger during the flow rebound; from 18-Mar to 19-May without liquidity effects would have suggested a rebound of 24%, while adjusting for liquidity effects suggested a 53% rebound. This shows how incorporating liquidity effects not only improves the fit through time, but also explains how inflows in an illiquid market (following a selloff) can drive a bigger increase than the drop caused by the same outflows that occurred when liquidity was stronger.

Again, that latter bit is crucial, and may well have quite a bit of explanatory power when it comes to the rebound off the March lows.

At this point, stating that many market participants have been “stunned” by the scope and rapidity of the bounce is something of a cliché. All manner of explanations have been offered to explain it, and I would suggest considering the above when you write your own history of what ended up being the most spectacular bear market rally of all time.

During selloffs, surging volatility diminishes market depth. When risk assets recover, subsequent buy flows/short-covering thus hit in an illiquid market. The impact of those flows is thereby magnified commensurate with the diminished state of liquidity.

The result: A turbocharged rally.


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7 thoughts on “The Role Of (Il)liquidity In History’s Greatest Bear Market Rally

  1. Thank you. It has been strangely amazing . This is why you do not fight the FED. I am and was a Bear by inclination. I had to take an active part in this obviously historic market. You have been a good guide Mr. H. I do believe it will be 2 years till we can catch our breath. Hope you keep writing because it would be too easy to become lost without you.

    1. Ha, you beat me to the praise, but seriously, I couldn’t have discovered this website at a better time (around February or March) considering the wild ride we’ve been on.

  2. I’ve said it before and I’ll say it again: thank you, H, for the education! Prior to finding your website, I would wade through all the garbage on CNBC or seekingalpha (which is ironically where I first came across your work) and just feel frustrated that nothing about the markets makes sense. I couldn’t understand why valuations seemed crazy or why the market was discounting the corporate debt that was accumulating over the last decade. Now I finally feel like it’s not all just chaos. Your website should be required reading in business school because it explains a hell of a lot more about how the financial world actually operates than any textbook or professor that I had.

    Also, your ability to understand and present all angles is unparalleled. I appreciate that you don’t pretend to know what the market will do next because, as you’ve said, if anyone knew that, they wouldn’t be telling everyone else about it. Subscribing to your site is some of the best money I’ve ever spent.

    1. One of the most important skills our educational system generally fails to help us learn is the ability to synthesize large amounts of information into an understandable essence. H has access to raw information most of us don’t and the time and skill to synthesize it into usable conclusions like no one else I have found. I might well have been one of those professors of which dayjob speaks. If I had been, I would have been reading H’s material along with my students. I know I will be reading this as long as H writes it.

  3. Thanks a lot H!
    What dayjob said.
    I guess most of your readers will gladly travel down the rabbit hole with you on any number of occasions if it promises the same level of education about modern markets.

    @ Michael: probably not, but the prospect of more stimulus might do the job. In a very perverse way the current rise in COVID19 cases might even be positive for markets insofar that it increases the chances of future stimulus (fiscal as well as monetary).

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