Strategy: The bogus argument of 'liquidity' - Kotak

The bogus argument of 'liquidity'. We dismiss the oft-repeated argument about 'liquidity' as a key driver of the market as completely spurious, which has no relevance for market returns. As an extreme example, we note that any unexpected positive or negative event can lead to the 'market' being marked up or down significantly without any significant money 'going in or out' of the 'market'. Anyway, for any trade there is a buyer and a seller and net activity is zero (in all senses of the word).

'Liquidity' argument is completely bogus in terms of determining market returns

We see absolutely no merit in the argument about 'strong liquidity' being the primary reason for the current strong run in global and domestic markets. To us, 'liquidity' simply means the prevalent 'combined' mood or sentiment of the market, which is based on expectations about either (1) improvement or deterioration in fundamentals (primarily earnings) or (2) continuation of prevalent trends. It is pointless to describe liquidity in 'money' terms since every secondary trade comprises selling and buying, resulting in net zero inflow into or outflow from the market. The market often confuses liquidity with institutional activity (net purchase or sale), in our view.

Imagine a scenario where the US Fed cuts policy rate by 100 bps

We would assume that all the global equity markets will get marked up heavily in a hypothetical scenario of the US Fed cutting the federal funds target rate unexpectedly by 100 bps. The first trades across all exchanges will result in stock prices and indices moving up significantly without any meaningful trades or money 'entering' the market. Since we are in a 'party' mood these days, we would not want to spoil the mood by looking at an 'alternative reality' of some catastrophe resulting in all global markets being marked down significantly without any meaningful trades on the exchanges or money 'leaving' the market.

Historical data of institutional activity and market returns is all over the place

We note that there is simply no correlation between institutional activity (net purchase or sale by institutional investors) and market returns as can be seen in Exhibit 1. Gross or even 'net' (adjusted for investments in equity issuances) institutional activity shows no relation with the actual market returns over any period. We would note that gross institutional activity (annual basis) has been consistently positive since CY2010 but annual market returns have fluctuated wildly and have been negative too in a couple of years. In fact, the gross or net flow number is simply a figure that sums up the institutional activity based on prevalent 'overall' expectations of earnings growth or market returns. Actual returns have little to do with institutional activity.

Expectations are temporary but earnings are permanent

We can only hope that the current excitement about the Indian market and especially the mid-cap. and small-cap. stocks reflects the market's confidence in a sharp recovery in economic activity and earnings and not simply expectations that the market and underlying stocks will deliver positive returns simply based on 'liquidity' and increased 'participation' by retail investors into the market. We note that for every Rs100 of investment made by a household in a domestic mutual fund and the subsequent purchase of Rs100 of investments made by the mutual fund, somebody will presumably sell the Rs100 of stock to the mutual fund.

Source : Equity Bulls

Keywords