Stock market liquidity, which offers the ability to buy or sell shares with minimal delay and minimal impact on the price, will trend sharply downward over the next decade, raising the risks for investors, per a detailed report from investment management firm Bernstein, as reported by Business Insider. In a worst-case scenario, constrained market liquidity can spark a meltdown in stock prices that sets off a new financial crisis. Three major recommendations from Bernstein are summarized below.

3 Ways to Survive the Liquidity Crunch

  • Increase cash allocations
  • Avoid unduly large positions and be wary of crowding risk
  • Develop active strategies to exploit the negative impact of liquidity

Source: Bernstein, as reported by Business Insider

Significance for Investors

The rationale for increasing cash allocations is straightforward. The same is true for reducing risk by avoiding unduly large portfolio positions and by being wary of crowded trades with the potential for severe selling pressure once market sentiment turns. Investors should also know how many trading days it may take to close a position in an orderly fashion, without having to dump shares at distressed prices.

Meanwhile, strategists at Jefferies recently identified stocks with heavy ownership by high-turnover hedge funds, as reported by CNBC. These stocks are at risk of coming under sudden and intense selling pressures once these funds head for the exits.

On their third recommendation, Bernstein says that the rise of passive investing is reducing liquidity. While they offer no specifics, they believe that active investment managers, like themselves, have the stock-picking expertise to thrive in this environment. However, a growing majority of actively-managed funds are underperforming their passive benchmarks, per research by Morningstar.

Bernstein identifies five forces that are draining liquidity. First, a combination of high frequency trading (HFT) and regulation have been factors spurring a drop of nearly 75% in bid-ask spreads during the last 10 years, but they say that volumes and turnover also have decreased.

Second, fewer investors in the public markets are driven by fundamentals. Instead, investors are turning to passive vehicles such as ETFs. "It can also pressure the more liquid holdings of investors if a larger share of their assets are tied up in illiquid positions that cannot be sold," as Inigo Fraser-Jenkins, head of global quantitative and European equity strategy at Bernstein, writes in a recent note to clients, as quoted by BI.

The third and fourth forces are the reversal of quantitative easing (QE) by central banks such as the Federal Reserve and rising corporate debt. The fifth and final force is the slowing of the economic cycle.

Plunging liquidity also is a major concern of analysts at Deutsche Bank. They see worrisome parallels today with the opening stages of the 2008 financial crisis and warn that a surge in market volatility is a likely consequence. Marko Kolanovic, global head of macro quantitative and derivatives research at JPMorgan, foresees a "Great Liquidity Crisis" in which the disappearance of willing buyers turns a stock market selloff into a full-blown crash.

Looking Ahead

A longstanding best practice for active traders is to be aware of average trading volumes and average bid-ask spreads. Trading in illiquid stocks with wide spreads is risky in normal times, let alone in times of market panic. Moreover, a trend towards lower liquidity market-wide also has ramifications for buy-and-hold investors who anticipate long holding periods, since eventually the day may come when closing a position is warranted.