Liquidity Versus Illiquidity; When Does It Happen?

One of the things you will hear people involved with markets talk about is liquidity. Liquidity means the ease at which you can unload a position.  A lot of people equate liquidity with volume, and there is certainly a correlation, but it’s not 100%.

The first ordinal in liquidity is the spread.  That’s the space between what people are willing to pay for something and what they are willing to sell it at.  The bid/ask.  Of course, listed commodity and stock markets show a Bid/Ask spread all the time.   The cost to trade it is the commission, and the width of the spread.

The second ordinal in liquidity is the size on the bid, and the size on the offer.  This means how many.  Can you unload 100, or just 1?  More size indicates more liquidity.   If you can only unload just 1, then the market has what is known as “slippage”.  Slippage means that to unload your position you will have to do it at a variety of prices.   Slippage increases costs.

The third ordinal is sheer volume.  Does the market trade a lot?  Or does it trade just a few times a day?  If it doesn’t trade a lot, you can still trade it but you are going to make your first ordinal spread a lot wider because you have to be paid for the risk you are taking.

This next point is obvious, but it’s something people forget.  Bear markets are illiquid, and go down faster than bull markets.  This is why falls happen faster than rallies.  When it’s a bear, everyone wants to sell, and no one wants to buy.  Markets aren’t exactly bottomless elevator shafts though.  There are rallies in bear markets.

This is instructive in today’s stock/commodity market, and in today’s venture capital market.

The stock market is self evident.  Turn on any business channel during a bear market and everyone is hyperventilating.  You see the color red (which affects your psychology by the way) and you might start breathing a little harder.  Big name stocks flash on the screen and instead of seeing +.4%, you are seeing numbers like -4%.  The total market is down big time this year.  Today, it looks like there will be a short bear market rally while the Bears hibernate for a bit.

There have been a series of posts by people on the state of the VC market.  They are excellent and you can read them here, here and here.  It’s bearish right now.  Since the VC market is totally illiquid, the bear bite can hurt and the falls are precipitous.  Think cliff jumping, not rolls downhill.

This is not 1987(Biggest crash since 1929).  It’s not 1998 (LCTM).  It’s not 2001(Nuclear Winter for Startups).  It is not 2008(Government supported bad Big Bank Behavior Crash).  This market feels more like the 1970’s to me than anything else.  Combine bad monetary policy, bad fiscal policy, bad government policy and you get a market that can’t sustain itself.

In a bullish VC market, it’s easier to raise money.  VCs and investors aren’t as concerned when founders and employees are cashing out of their shares in financing rounds.  They might even encourage it because they want to buy more equity.

In a bearish VC market, it’s just a fight for survival.  It seems equity isn’t worth a Continental.

What do you do if you are a startup person?  First, find a reason not to worry about it.  Brad Feld writes, “Take a very deep breath. Figure out what you can actually impact today, and then go do it. And shut out all the rest of the noise.”  I agree +10,000.

Second, if your startup is showing signs of growth, don’t worry about it.  You must have found a pain point and you are solving it.  Eventually you might run into a wall if you don’t have true product/market fit but that’s not a worry for today.

Third, if your startup is dead in the water, you are going to have problems.  You will need to take a step back and see if there is a way to pivot into something that gets you on the growth curve again.  If there is no pivot, well, it might be time to roll it up, return as much money as you can to investors and move on.  Live to fight another day.

Fourth, if you were going to launch a startup and you saw all markets tank, you probably still should launch it.  There are legions of startups that were launched in bad economic times.  One of the reasons they became successful is that people were more willing to take a risk on them.  Another is the pain points more readily avail themselves in bad markets.  It’s easier to find problems to solve!

Ironically, this bit of advice works in bear and bull markets.