Ross M. Miller
Miller Risk Advisors
June 28, 2004
Alas and alack, astronomical summer is here. With each
day that the black swan or raven fails to come
a-tapping at my chamber door, the market trends lazily upward and the VIX
trends lazily downward. Even the occasional videotaped beheading serves
only to reinforce this trend, making the misdeeds on the allied troops
appear little more than a frat hazing gone awry.
Still, it warms my heart to see the VIX trading in its
own futures market. Who could have ever imagined that the numerical
solution to a nontrivial partial differential equation would become a
marketable commodity? Whatever will they think of next?
To my second question, I proffer a general suggestion;
however, I must insist on keeping the details to myself.
It's summer. Think of ice cream. Think of ice cream
melting down the side of a sugar cone. Think LIX. Liquidity index. Now
hold that thought while I take you on a journey.
Somewhere there is a world of infinite liquidity and
infinite capital at fixed interest rates. Need to sell some stock? Need to
sell all the stock on the world's exchanges? It's done. In a flash. Don't
worry about the market impact. The bid always equals the ask. For a
hundred shares. For a billion shares. It makes no difference. And no more
margin calls, all the capital in the universe is available at one low
fixed rate. And not just while supply lasts, because supply is infinite.
What a deal!
(The squeamish should skip this paragraph. It is not
necessary for supply and demand to be infinite in a strict sense in order
for theories that assume perfectly competitive markets to work. It is
sufficient that individual supply and demand, though nonzero, be
infinitesimally small, where "infinitesimal" is a mathematical
term with a precise definition that no real-world object satisfies.)
Where is this world? In the finance textbooks, of
course. It was there when I picked up the first edition of Brealey and
Myers hot off the presses and it's still there today. CAPM, APT,
Black-Scholes-Merton, NPV, you name it--all of them only work as
advertised in this wondrous fantasy land.
Do the names Scholes and Merton ring a bell? Of course,
they do. The hedge fund they were partners in, Long-Term Capital
Management (LTCM), died on the cross of infinite liquidity and infinite
capital. Guess what? Both liquidity and capital are, indeed, finite. That
means, according to basic economics, that both of them should have a
In the case of capital, it turns out that it really was
finite all along only there was so much of it around that any demand that
one of us might make on the capital market would seem small by comparison.
That is, unless we were LTCM.
Liquidity is different, though. All the textbook
theories (though not some newer theories that will require a new
generation of textbook writers to explain properly) assume that price is
what mathematicians refer to as a well-defined number, preferably
rational. When I ask the question "What is the price of GE?" the
textbooks implicitly do not accept "It depends," "Are you
buying or selling?" or "What do you mean by 'price'?" as
acceptable answers. They live in a world where the answer is something
like $31.23 per share and that applies to one share and one billion shares
I remember reading soon after the LTCM collapse that
Myron Scholes pithily explained the fund's predicament as being "long
liquidity." I don't know if Myron then went on to conclude the
obvious, which was that LTCM needed to hedge its position with a contract
that would be short liquidity. That's where LIX, the liquidity index,
Just like bond prices and interest rates, LIX moves in
inverse proportion to the amount of liquidity in the market. In the
oh-so-pleasant dream world of infinite liquidity, liquidity has an
implicit price of 0, and so the LIX is 0. The less liquidity there is the
benchmark market, the higher LIX goes. During the Russian debt-induced
crisis of 1998, LIX would have gone sky-high and if it had existed back
then and had LTCM held LIX in sufficient quantity to hedge its long
liquidity position, everything would have been hunky-dory.
Please note that while CNBC, the Wall Street Journal,
and the rest of the financial press have some unnatural fascination with the
notion of Alan Greenspan "pumping up liquidity" as measured
by M1, M2, M3, or Mwhatever, that is not what I am writing about here, at
least not directly. The "true" LIX indicates the ease with which
one can buy or sell a suitably chosen portfolio of securities in volume.
More problems mean a higher LIX.
There are some technical issues involved in how one
would construct LIX, but the details are left, as the textbooks say, as an
exercise for the reader. There is also a peculiar paradox involving the
LIX, but then it is hard to find a financial theory that is not, when
inspected closely enough, paradoxical if not outright self-contradictory.
If you haven't figured it out already, everything
written about in these commentaries on www.millerrisk.com
in the past few weeks is linked in some way to what is going on at RiggedOnline.com,
where Chapter 6, with the alluring title of "Foreplay," is being
posted simultaneously with this commentary.
Looking ahead, I am celebrating my personal independence
by not writing an Independence Day commentary, though new chapters of Rigged
will continue to roll out every Monday and Thursday at the sibling site.
The following Monday, July 12, if I still have the nerve and if the
markets do nothing worthy of my attention, I will begin a multi-part
series describing real life (or, better yet, my view of it) on Wall Street
during the summers of 1971 and 1972--a golden age of liberated women and
regulated commissions. You can judge whether truth is stranger than
Copyright 2004 by Miller Risk Advisors. Permission
granted to forward by electronic means and to excerpt or broadcast 250
words or less provided a citation is made to www.millerrisk.com.