US stock market liquidity is ‘abyssal’, adding to volatility risk

A ‘Wall St’ sign is seen above two ‘One Way’ signs in New York August 24, 2015. REUTERS/Lucas Jackson

NEW YORK, Feb 7 (Reuters) – Liquidity in U.S. stocks has fallen to levels not seen during the COVID-19 sell-off two years ago, adding volatility to an already jittery market.

Market liquidity, or the ease with which investors can buy or sell a security without affecting its price, has been on a downward spiral for years. Over the past few weeks, however, traders have been surprised by massive moves.

“Liquidity is abysmal, that’s how I would describe it,” said Rishabh Bhandari, lead portfolio manager at alternative investment management firm Capstone Investment Advisors.

“As soon as someone wants to shift risk, there’s no effective mechanism for people to do that.”

Analysts said liquidity was affected as active investors buying and selling opportunistically were eclipsed by automated trading and passive investment strategies. They also blamed tighter regulations that discouraged risk taking by some brokers.

On Thursday, for example, Facebook’s parent company Meta Platforms (FB.O) plunged into the biggest daily drop ever for a stock of a U.S. company, losing more than $200 billion in market value. Read more

Wall Street’s fear gauge, the Cboe Volatility Index (.VIX) hit a 15-month high of 38.94 last month, amid a plunge in stock prices that left the Nasdaq lower by 9% and the S&P by 5.3% in January in the face of a hawkish shift by the Federal Reserve.

The liquidity problem is not limited to individual stocks. E-mini S&P 500 futures, one of the world’s most followed financial instruments, are also showing a sign of danger.

Low liquidity exacerbates market fluctuations and makes it more difficult for investors to execute buy and sell orders at a desired price. Episodes of low liquidity contributed to wild market swings in March 2020, when the S&P 500 fell about a third from peak to trough as investors worried about a COVID-19-related economic shutdown. .

One measure of stock market liquidity is the depth of the S&P 500 e-mini futures market, which investors use to gain exposure to the US stock market.

These futures contracts typically trade around $50 million in notional value at any given time. That number fell to around $2 million at the end of January, not far from the $1 million to $1.5 million level reached in March 2020, according to Capstone data. It now stands at just under $5 million.

Another liquidity metric shows the share of exchange-traded funds as a percentage of total equity volumes at 45%, the highest in at least two years. Low liquidity in individual stocks has prompted investors to increase their use of equity ETFs, according to JP Morgan.

In addition to the March 2020 selloff, deteriorating market liquidity contributed to stock market corrections in September 2021, October 2020 and December 2018, JP Morgan analysts said in a recent note.

“A similarly sharp deterioration in stock market liquidity conditions appears to have exacerbated recent market movements,” they wrote.

Investors attributed the cash crunch to a variety of factors. On the one hand, they said that tighter regulations in the aftermath of the global financial crisis have reduced the ability of large brokers to take risks.

Another factor has been the shift to market making for securities from humans to machines. According to experts, trading programs sometimes reduce liquidity when volatility increases, which can exacerbate market movements.

Additionally, some investors cited the rise of passive investment strategies. While active managers seeking trading opportunities have always provided liquidity in times of stress, systematic and passive strategies may not be allowed to do so due to strict rules on how and when to trade.

“Liquidity risk is grossly underestimated,” said Steve Sosnick, chief strategist at Interactive Brokers and a former options market maker.

“As investors rush to win stocks, they’re becoming oblivious to the fact that it’s getting harder and harder to get out in droves.”

Reporting by Saqib Iqbal Ahmed; Editing by Ira Iosebashvili and David Gregorio

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