The Impact of Liquidity on Asset Prices
Investing in assets can be a complex endeavour, requiring a deep understanding of various factors that influence price movements. One often overlooked aspect is the role of liquidity and how it impacts asset prices. In this article, we will delve into the relationship between liquidity and asset valuation, using a real-life example to shed light on this critical concept.
The Misunderstood Role of Liquidity
When examining discussions around asset prices, it becomes evident that people often underestimate the significance of liquidity. Many believe that as assets become more valuable, liquidity flows into the market, driving prices higher. However, this perspective fails to acknowledge the inverse relationship between liquidity and asset potential.
Contrary to popular belief, liquidity is not the cause of asset valuation but rather a consequence of it. Assets possess inherent potential, which attracts liquidity and subsequently drives up prices.
Case Study – Alibaba Stock
To illustrate this point, let’s consider the case of Alibaba stock. This renowned Chinese company experienced a significant price fluctuation, highlighted by an infographic in the Financial Times. In 2020, the stock soared from $80 to $315 before plunging back to $69 with its current value hovering around the $70 mark.
Now, put yourself in the shoes of an investor in this stock. You’ve spent nine years without any returns and witnessed an alarming 80% drop from the stock’s peak. Moreover, liquidity has exited the Chinese market, a clear indication that the heydays of liquidity-driven asset pricing have come to an end.
During the years 2016, 2017, and 2018, liquidity steadily flowed into the Chinese market, bolstering asset prices. However, in 2019, foreign purchases of Chinese stocks plummeted, and by 2023, they had collapsed entirely. Thus, it becomes clear that the surge in asset prices during the heydays was primarily driven by liquidity rather than justified by earnings or other fundamental factors.
The Importance of Liquidity Awareness
If you find yourself investing in a weakened stock that has lost substantial ground, your strategy becomes centred around waiting for liquidity to return to the market or the stock to take actions that reignite interest from liquidity providers. However, the road to recovering from an 80% loss and reclaiming past levels is not easy, as you cannot simply dictate the flow of liquidity into your stock or market.
This is where understanding price action becomes crucial. Price action refers to the movement of an asset’s price over time, and it conveys valuable information about market sentiment and liquidity conditions. By closely monitoring price action, investors can gain insights into the market’s perception of a stock, its liquidity prospects, and potential turning points.
Even during times when liquidity seems abundant, paying attention to price action can prevent investors from experiencing substantial losses. In the case of Alibaba stock, despite strong liquidity in 2021, the stock was trending downwards. By closely following the price action, investors could have exited the position at $262-$240, minimizing their losses to around 20-25%, rather than enduring the significant 80% drop.
The Danger of Infinite Belief in Liquidity
It is essential to recognize that liquidity is not an infinite resource that will perpetually flow into a given stock or market. If liquidity starts to dwindle, it indicates that something is amiss. Respect liquidity and heed the warning signs conveyed by price movements.
In the case of Alibaba stock, the decline in liquidity was a red flag signaling underlying issues. Investors should take note and avoid falling into the trap of assuming that liquidity will perpetually favor their chosen stock. Understanding that liquidity withdrawal suggests an underlying problem is crucial for making informed investment decisions.
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