Value investors understand that there’s a big difference between price and value. Price is what something sells for now. Value is what it is actually worth to a buyer.
In “normal” market conditions and across asset classes in general (subject to limited exceptions in individual cases), value and price tend to closely approximate each other. But during periods of irrational exuberance or of panic, the price and value of entire asset classes can diverge, and sometimes by a lot.
Panics (like we are experiencing now) force people to sell certain types of assets en masse for this reason or that. What distinguishes a panic from normal market volatility is that the sellers in a panic generally don’t want to sell these assets but rather are forced to do so. And en masse. And all at once.
What forces them to sell?
Well, panics tend to happen when liquidity (access to cash) begins to dry up within a highly leveraged (that is, indebted) system. As that happens, interest rates (the cost of being able to access cash) begin to rise. The rapidity of any such rise indicates just how quickly liquidity is drying up and so just how desperate the panic is. It’s the rate of change in interest rates (more than the absolute rates themselves) that is the real “tell” and that has the greatest impact on markets and psychology.
And we are currently living through the most rapidly rising interest rate environment in history, meaning that there are epic levels of panic in the system.
Why the panic?
Businesses need cash to make payroll, pay suppliers, etc. Businesses and ordinary people especially, need cash to pay their debts (student loans, credit card payments, car payments, mortgage payments). And we are currently more indebted than at anytime in our nation’s history, and by far, so the demand for cash is high.
So as the supply of cash gets more and more scarce (and it's presently the Federal Reserve’s explicit policy to make it so), people and businesses become fearful that they won’t be able to pay their debts or meet payroll—that is, that they will go bankrupt. So they reduce their spending en masse, which reduces the velocity of money and makes cash even more scarce. Eventually, after exhausting most or all of their cash reserves, the only option available to them to raise sufficient funds to stay afloat is to sell what assets they quickly can.
Alas some types of assets are much harder to sell than others. For this reason they tend to sell their best —that is, their most liquid—asset classes first.
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Let's have a practical example
Imagine your own monthly cash flow being suddenly disrupted. How would you pay your bills? You’d likely drain your checking account (your most liquid) asset first. Then perhaps your savings account (the next most liquid asset). Then perhaps stocks, bonds, mutual funds or crypto assets you may directly own (all also quite liquid in that they can be sold with the press of a few buttons). Then maybe your IRA or 401(k) (less liquid due to early withdrawal penalties, but still readily available). Then maybe you’d pawn your gold jewelry. Then eventually maybe your car. Then if necessary months or years later, your house.
The key insight is that its often the best (most liquid) assets that get sold first during a panic, not because they are bad assets but precisely because they are good ones (the ones most readily and reliably converted to the much-needed cash).
As these liquid assets get sold all at once during the panic, their prices understandably (but usually temporarily) collapse. In severe panics they collapse hard.
Unfortunately unsophisticated “investors” interpret these crashes as evidence that something is wrong with these assets classes—that they are “dead”, or “no good” or “worthless” or a “ponzi”, and, joining the panic, they too mindlessly dump entire asset classes even when they don’t necessarily need the cash. This aggravates the panic.
But once the crash is over—that is, once the system painfully right sizes itself to the new lower liquidity levels, or once the Federal Reserve starts making liquidity more readily available again—the panic selling slows and eventually stops. People who were unable to access sufficient liquidity have now bankrupted and been liquidated, so they don’t need and aren’t able to sell anymore. And people who managed to stay liquid and survive the downsizing likewise don’t need or want to sell. Instead they can (and do) scoop up some of the world’s best and most liquid assets at bargain basement prices. As they do so, the price of these asset classes begin to skyrocket. Over time these prices may recover entirely, or in some cases more than fully recover.
The above dynamic means that, with the notable exception of cash, the most valuable and liquid of assets are usually also the most volatile during times of panic. People uncritically (and often wrongly) interpret this volatility as evidence that the asset is “risky” or that it now lacks “value”. They make very poor decisions as a result.
The liquidity driven volatility in these assets is why their prices are so often viewed as leading indicators, meaning that they reasonably reliably tell us in advance the direction in which the economy is going and how far it's likely going. Their prices often begin to fall even in the very early stages of a liquidity driven panic, before any real panic is even evident. And they often begin to recover, sometimes rather sharply, just as it seems that all is lost and the panic will never end. These assets are such good barometers precisely because they are so liquid and therefore so desirable.
As many of the world’s greatest investors have often said, the time to buy (these liquid asset classes especially) is when blood is running the streets, even if that blood is your own. But only if you’re confident you’ll be able to hold these assets for an extended period of time without being forced to sell. Which is easier said than done because, to paraphrase another famous investor, markets can stay panicked longer than you can stay solvent. Given that, buying such assets with leverage (debt) is among the silliest things the average investor can do.
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