- The US stock market rarely faces hurdles for those looking to freely buy and sell shares, but a Wednesday note from Bank of America details how the S&P 500 index could face a liquidity crisis in the near future.
- Nearly half of all US stock ownership is passive, and a widening gap between bid and ask prices is stifling potential trades.
- Money managers are also shifting funds into long-term vehicles and short-term bets, retreating from the medium-term strategies that drove consistent liquidity in markets.
- Even active investors are contributing to the problem, crowding into the index’s largest momentum companies at levels similar to “record Tech Bubble levels,” the analysts wrote.
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The key index’s components are increasingly bought by passive funds over active investors, leading stock fundamentals to take a back seat to fund flows. Nearly half of all US stock ownership is passive, BofA wrote, and the stocks held in such accounts have seen wider bid-ask spreads than usual. A wider gap between “buy” and “sell” prices quashes potential trades and suppresses stock liquidity.
Money managers are adding to the problem by loading up on short-term investments like algorithmic trading programs and long-term vehicles like private equity funds, BofA said. The shift dissolves many of the medium-term strategies that drove consistent liquidity in markets, they added.
“Investing appears to have turned into an extreme sport,” the team led by Savita Subramanian wrote in a note. “Similar to the hollowing out of the middle class within the US, we have seen a hollowing out of the medium-time-horizon investor.”
Even active investors are contributing to the liquidity squeeze. The group is piling more cash into a fewer assets, with their holdings in momentum stocks often overlapping. The S&P 500 is now “very tail heavy,” the analysts said, as the 10 largest members represent a quarter of the index. That level of concentration in momentum stocks is similar to the crowding seen at the peak of the technology bubble, the bank added.
Pension funds are copying broad move into passive assets, growing their exposure to illiquid investments to 24% today from 8% in 2006, according to BofA. Much of the funds’ passive holdings reside in private equity, and such assets are “relatively untested” for environments of increased capital costs or higher return expectations, the analysts said.
The analysts warned that, should private equity assets underperform, pension funds “may be forced sellers” of assets held in passive exposure to the S&P 500. Such a sell-off could tank the index and place massive downward pressure on the greater US stock market.
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