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A Look at the Liquidity Premium


It looks better than anytime over the past few years!


One of the mantras discussed here over the years has been liquidity. The need for it, the excesses of it, the dangers of it…you can find a good discussion of the macro and the micro by a simple search on Minyanville.

We're going to take a little different tack today and not look at the supply of liquidity, but rather traders' demand for it. Today we're looking at the Liquidity Premium.

What is it?

The Liquidity Premium is based on a simple concept – when traders are uncertain about market direction, they will migrate to the vehicles that provide them with the greatest chance of entering and exiting positions with a minimal amount of execution risk.

Over the years, two of the instruments that have emerged as the "liquidity kings" are the S&P 500 and Nasdaq 100 exchange-traded funds, SPY and QQQQ, respectively. Trades worth tens of millions of dollars can be crossed without much of a hiccup in the underlying, and as such they provide a way for individuals and funds of (almost) any size to put on or take off equity exposure very rapidly and with a minimal amount of slippage. They're also usually easily shortable in a down market.

By watching the volume flowing into these ETFs, we really only see one side of the equation. Just because volume in the ETFs is high, doesn't mean much from a sentiment perspective if volume in the underlying stocks is heavy as well. Therefore, the Liquidity Premium compares the volume in the all the underlying components of each index, and compares it to the volume in the funds on an apples-to-apples basis.

Why should we follow it?

ETFs have become extremely popular, as we all know. Every week, there is a new batch of funds launched to the public, and personally I think it's great – the more choices for investment, the better (though perhaps it's gotten a bit ahead of itself…do we really need something based on the S&P 500 O-Strip index?).

Because of their popularity, many ETFs have become the first choice for investors, large and small alike, that want instant exposure in very liquid instruments. This "first choice" feature makes the funds useful for determining when traders are eschewing individual equities. Also, volume data is available on a real-time basis, so we can see even intraday how the flows are shifting.

What are the challenges in using it?

The ETF craze is a relatively new phenomenon, though the granddaddy SPY and QQQQ funds each have at least five years of history. Still, five years isn't a real long time when we want to compare recent readings to historical extremes, so that is one limitation.

This type of comparison is also not necessarily effective on a universal basis. I compute the Premium for SPY, QQQQ and SMH, but really only the first two have any consistent value. I've studied it for RTH, GLD, BKX, and a few others, all with the same inconsistent results. I think the reason is that in order for the concept to be valid, traders must have the mindset that they can get in or out at the current price no matter the time and no matter the circumstances, and only SPY and QQQQ come close to that ideal.


What's it suggesting now?

Over the past week and a half, we've seen several exchange-traded funds hit new all-time record highs in volume. This is not uncommon in times of stress and uncertainty, and that's why this indicator has proven useful time and again.
You can see from the chart above that the Liquidity Premium for SPY has shot higher lately. Not only has volume in the ETFs been tremendous on an absolute basis, it has also far, far outpaced the volume in the underlying equities. This suggests that traders have had a definite preference for the liquidity of the exchange-traded funds over that of individual equities.
The Premium is now as high as it has been at any other time over the past couple of years and is at a point that I would certainly consider it extreme. Not to be picky, but it's not quite at the levels we saw at the lows prior to 2003 – at those times, the Premium shot up to levels 50% higher than where they are now.
So how much you want to consider this a bullish omen for the market at this point depends on how much you believe we're still in a positive market environment. If your belief is that we're in something approximate to the past few years (and the evidence so far is too early to suggest otherwise), then this is one piece of evidence you can point to that suggests that perhaps this rally might last more than a few days.
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No positions in stocks mentioned.

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