The Tell: S&P 500 liquidity risks could compound market selloff, says BofA

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A shortage of cash has been a prominent feature of the market for overnight bank-to-bank lending in recent weeks, leading to an up to 10% spike in borrowing rates that has forced Federal Reserve to add liquidity to this market by providing billions of dollars in loans on a daily basis since Sept. 17.

A similar shortage of willing buyers and sellers of stockscould soon roil equity markets, according to a recent analysis by Bank of America Merrill Lynch.

“When the wall of worry turns to panic selling, we worry about an unlikely area of liquidity risk: the S&P 500, the equity benchmark perceived to be more liquid than most,” wrote Savita Subramanian equity and quant strategist at Bank of America, in a note to clients.

She argued that in recent years, trading volume for large cap U.S. stocks increasingly has been provided by “non-fundamental investors” including algorithmic investment funds, passive investment funds and high-frequency traders.

Therefore, “average trading volume for S&P 500 stocks has been falling for years,” Subramanian wrote. “Banks no longer provide the same liquidity as [before the Great Financial Crisis]. The result is a bid-ask spread for the average S&P 500 stock that is close to a multi-year high.”

Bank of America Merrill Lynch

Liquidity drain in S&P 500

The rise of passive investing may create liquidity concerns because “buying and selling disciplines are determined solely by inflows and outflows,” Subramanian wrote — think investors putting a predetermined portion of their incomes into a 401(k) account. Meanwhile, stock exposure has become abnormally concentrated in specific securities, creating a situation where there may be few buyers for these stocks once a market downturn occurs.

“At an asset owner level, pension funds’ exposure to private equity has risen demonstrably amid a reach for returns,” she added. “But any disturbance to private markets (IPO friction, funding shocks via credit or rates) could force pensions to raise cash for distributions by selling the more liquid parts of their portfolios, namely public equities.”

Subramanian warns that liquidity concerns could cause trouble for markets during the first ten days of October, when investment funds tend to unwind positions for tax-loss selling and quarterly rebalancing. The Dow Jones Industrial Average DJIA, -1.83%, the S&P 500 index SPX, -1.73%  and the Nasdaq Composite index COMP, -1.67%  were all down more than 2.1% for the first two trading days of October, as of midday Tuesday.

Oct. 31st could be another date where liquidity concerns arise, as it’s “mandated cut-off for mutual funds to realize capital gains vis a vis the Tax Reform Act of 1986” and Dec. 31st may cause trouble as it’s the end of the fiscal year for most U.S. mutual funds.