Ephemeral Liquidity

Howard Marks, the legendary founder of Oaktree Capital Management, is out with his latest quarterly memo and it is titled “Liquidity”. Marks offers us a treatise on liquidity in capital markets as he delves into the illusion of liquidity that many investors assign to mutual funds and ETFs. He also reviews the costs of liquidity, both implicit and explicit.

The following excerpt is a textbook example of Marks’ mastery of conveying financial market concepts with ease:

“It’s often a mistake to say a particular asset is either liquid or illiquid. Usually an asset isn’t “liquid” or “illiquid” by its nature. Liquidity is ephemeral. It can come and go. An asset’s liquidity can increase or decrease with what’s going on in the market. One day it can be easy to sell, and the next day hard. Or one day it can be easy to sell but hard to buy, and the next day easy to buy but hard to sell.

In other words, the liquidity of an asset often depends on which way you want to go…and which way everyone else wants to go.” 

We have witnessed this phenomenon of ephemeral liquidity on numerous occasions, however, it usually only becomes pronounced during times of extreme financial market stress such as the 2008-2009 Global Financial Crisis or the 2007-2010 US real estate market crash.

We are experiencing this phenomenon currently in the Canadian junior resource space as liquidity is only available for the best names in the sector and investors are pushing for very cushy terms in return for providing companies with financing. Marks also discusses the opportunity that arises from markets which are illiquid:

“On the other hand, at the right time, investors can make tremendous amounts of money simply by being willing to supply liquidity (or accept illiquidity)…

A high degree of concern over illiquidity can push investors to avoid it to excess. For example, institutions whose realities could permit a long-term investment approach sometimes decide to invest only in things they can get out of quickly.” 

This is exactly the condition we are witnessing in the junior space as investors still stung from the recent multi-year bust period are reluctant to get involved with anything. It will be the investors who step in to provide liquidity and/or who are willing to accept illiquidity who will profit handsomely over the coming years.