<November 27, 2023>
For those considering moving to Florida, instead of checking with your real estate agent, you might want to speak with your insurance agent! We just received our homeowner’s insurance bill, and it spiked again this year (Twas the Bill Before Christmas). While investors celebrate the declining rate of inflation, and the dollar they’ll save on their next purchase of eggs, the cost of insurance and homeownership continues to soar.
The cost of home renovations have also increased over the past several years. Our home hasn’t been renovated in 15 years and could use a little refresh. We recently researched updating a bathroom and received three written quotes. All three came in significantly higher than the original estimate.
Prices are interesting—what you see isn’t always what you get. And that’s especially true in the small cap market. Prices can change violently and without notice. Until a trade is placed and completed, the actual price can look quite a bit different than the initial quote.
If prices are interesting, liquidity is downright fascinating. Investors try to measure it and make it quantifiable. We pretend we can define it, control it, and understand it. We can’t. Liquidity is there or it isn’t. It can be plentiful one minute and vanish the next. Liquidity can be a blessing or a curse—it is risk and opportunity.
For professional investors, liquidity can make or break careers. Take advantage of it and thrive, or get caught on the wrong side and pay a heavy price. Investors that must complete an order regardless of price are at a disadvantage. Conversely, investors with liquidity (cash), patience, and flexibility have an advantage.
As absolute return investors with the ability to hold cash, we believe our valuation-driven process helps us remain on the right side of liquidity. When investors are rushing to exit stocks and valuations are attractive (2020), we tend to be buyers. When valuations are expensive and investors are chasing stocks higher (2021), we tend to be sellers. We view our buy and sell discipline as a natural hedge against liquidity risk.
Over the past two months, we’ve been trading more actively. As we discussed in “Soft Serving a Hard Landing,” we were beginning to find opportunities in stocks that were beaten down by rising interest rates. As stock prices fell, we became more interested and began to do some buying. Although prices were falling, buying wasn’t as easy as we experienced in past market declines. Sellers appeared timid and uncommitted. When our bids showed up, prices often rose and moved away from our limits. Sellers either didn’t have enough shares or weren’t interested in trading larger amounts. In effect, the prices were good, but the liquidity wasn’t.
There are many studies and estimates related to computer-driven trading. Whether it’s 70%, 80%, or 90% of total volume, algorithms conduct the majority of stock market trading. We haven’t done our own study but can feel their presence when we trade. Our view is algos are fickle, two-faced, and create a tremendous amount of noise. They don’t care about valuations or fundamentals, just direction. They inflate trading activity and provide misleading measurements of liquidity. And when liquidity is needed most, their bids and asks often disappear or shift to the prevailing trend. Whether it’s the November 14, 2023, melt-up in small cap stocks (up 5% in one day) or the 2010 flash crash (the Dow Jones fell 9% in minutes), we believe computer-based trading amplifies price swings and is an unreliable source of liquidity.
State Street is currently running a clever television commercial promoting its Dow Jones Industrial Average ETF (DIA). The commercial begins with a young couple riding in a hot air balloon. As the couple enjoys the view, the man kneels, pulls out an engagement ring, and performs a perfect marriage proposal. Unfortunately, the proposal falls flat, and the young lady declines his offer. The couple soon realizes they’re trapped in an incredibly awkward moment for as long as they’re in the balloon together. The commercial ends with, “Whatever you get into, make sure you can get out. Be ready for any market with a liquid ETF.”
As investors crowd into passive funds and ETFs, liquidity is being promoted as one of the selling points. Assuming all assets are eventually converted from active to passive management, does liquidity risk go away entirely? Of course not. ETFs own individual securities that must be bought and sold. However, for now, the steady upward march of passive assets under management is doing wonders for prices and the perception of liquidity.
In our opinion, the combination of computer-based trading and consistent flows into passive strategies have put liquidity risk in the back of most investors’ minds. However, as we recently experienced on the front lines trading small cap stocks, we believe liquidity risk is alive and well. Although prices, volumes, and spreads may currently paint a picture of abundant liquidity, we believe investors should remain alert for jittery bid and ask prices, along with abrupt shifts in volatility.
The recent Wall Street Journal article “What’s Behind the Market’s Wild Overreactions” looks for answers as to why stocks have been so volatile. The article suggests recent moves in the stock market appear “out of whack with what happened.” Pointing to the CPI report on November 14th, which showed year-over-year inflation of 3.2% versus expectations of 3.3%, the article states, “Good news, for sure, but clearly not enough to justify a 5.4% leap in the Russell 2000.” In our opinion, it’s less about the news, and more about the lack of depth behind today’s bid and ask prices. In other words, it’s not fundamentals, it’s liquidity and pricing that lacks conviction.
We believe liquidity risk cannot be eliminated by computer-based trading and funneling more assets into passive funds. The great opportunity of the current market cycle, in our opinion, will be when the share of passive assets peak and passive flows reverse. Assuming this happens, passive managers will inform their traders that instead of buying, they’ll be selling. And since passive funds hold a very small amount of cash, they’ll likely instruct their traders that their sell orders must be completed on the same day that outflows are received. When the traders put in their sell orders, the same algos that got in front of their buy orders on the way up will get in front of their sell orders on the way down. At that time, we expect the combination of algorithmic trading and passive outflows will create tremendous opportunities for those with liquidity.
We believe the passive crash is a real possibility. While we may be wrong, it is one of the reasons we launched Palm Valley Capital—to take advantage of the resulting value. Regardless of the ultimate catalyst, we hope to be on the right side of liquidity when the current market cycle ends.
Eric Cinnamond
The Palm Valley Capital Fund can be purchased directly from U.S. Bank or through these fund platforms.
Index performance is not indicative of a fund’s performance. It is not possible to invest directly in an index. Past performance does not guarantee future results. Current performance of the Fund can be obtained by calling 904-747-2345.
There is no guarantee that a particular investment strategy will be successful. Opinions expressed are subject to change at any time, are not guaranteed, and should not be considered investment advice.
Fund holdings and allocations are subject to change and are not recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk. Click here for the fund’s Top 10 holdings.
Mutual fund investing involves risk. Principal loss is possible. The Palm Valley Capital Fund invests in smaller sized companies, which involve additional risks such as limited liquidity and greater volatility than large capitalization companies. The ability of the Fund to meet its investment objective may be limited to the extent it holds assets in cash (or cash equivalents) or is otherwise uninvested.
Before investing in the Palm Valley Capital Fund, you should carefully consider the Fund’s investment objectives, risks, charges, and expenses. The Prospectus contains this and other important information and it may be obtained by calling 904 -747-2345. Please read the Prospectus carefully before investing.
The Palm Valley Capital Fund is distributed by Quasar Distributors, LLC.
Definitions:
Bid and ask: Bid and ask prices are market terms representing supply and demand for a stock. The bid represents the highest price someone is willing to pay for a share. The ask is the lowest price where someone is willing to sell a share.
Spread: The difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.
Dow Jones or Dow Jones Industrial Average: The Dow Jones Industrial Average, or Dow Jones, is a stock market index of 30 prominent companies listed on stock exchanges in the United States.
Dow Jones Industrial Average ETF (DIA): An ETF that seeks to provide investment results that, before expenses, generally correspond to the price and yield performance of the component stocks of the Dow Jones Industrial Average.
ETF: An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund. Typically, ETFs will track a particular index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can.