Tuesday, June 13, 2006

Market Crashes and Liquidity

VIX is at 23.81 - more than double it's recent "normal" levels. Emerging markets are discounted by 30, 40, even 50% (Turkey, Russia). Inflation is a real threat, interest rates are an unstoppable freight train, the last outpost of income - real estate - is agreed upon as inevitably "doomed", Oil shortages, etc., etc., etc.

Question: In the backdrop of all these wonderful things, why haven't we crashed?

Answer: With all due respect, I think we have.

The reason it doesn't "look" like we have is liquidity. If we contrast today's sentiment to that of August 2000, when then Nasdaq bubble whooped out of existence, it isn't all that different. The only difference is the degree of maturity of the U.S. markets and ensuing liquidity. In short, no matter how bad the sentiment gets, there is still a continuous flow of bids out there. That's markedly dfferent from the dot com era when things imploded because noone was around to buy them.

Contrast this yet again to the newer "hot" markets like India and Russia and you get the familiar implosion effect: remove liquidity and the bids dissappear. This simple mechanism has everything to do with the amplitude of the resulting moves.

Bottom line: I don't think we'll witness a real "crash" in the U.S. indices. There are too many players on both sides of the fence and unless the whole world goes to war, they are likely to remain. That's why I still feel that treating emerging markets as an exaggeration of today's sentiment is proper; U.S. is really the same - we are just "saner" because we have more hands in play.

So, I think a point can be made that we did in fact "crash": the world did a real 1987 and the U.S. did a "mature" version of it.

Granted, in the longer term this will probably get worse before it gets better. But I think at this point you can bet on the "worse" part not being all that terrible.



At 4:10 PM, Blogger real1 said...

Interesting observation. The structural difference and the fact that the ESF might be involved.

At 2:33 PM, Anonymous Anonymous said...

Dmitry - just found your blog. I like what I've read so far and will go back and read all the history soon. Very much agree with your comments re maturity and liquidity which is I guess one of the philisophical underpinnings of my trading style, which seems eerily similar to yours...

Currently (scaling) long TOL, Nikkei and Eurodollars - how are you faring in the in-between world we're in now - ie had the fall and had a good bounce...always scratch my head when it gets like this!

At 11:51 PM, Blogger Dmitry said...

When the sky falls and bounces, it is almost a gamble to game the next move. The reason for this is that in this case the price moved from one extreme, to another and then settled in between. Since "gameable" probabilities exist only at extremes, the stuff in the middle isn't really worth worrying about - you will likly end up being really right or really wrong.

Wait for the rubber band to stretch and then look for the next trade.


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