Editor's note: As we shared yesterday, liquidity risk is important to consider before you invest in any stock. And as Dan shared, even the liquidity of mega-cap stocks can suddenly evaporate. Today, he extends this idea further and explains how liquidity has the ability to dry up entire markets... and what you can do to protect your wealth when it happens.

Prices Don't Glide... They Leap

By Dan Ferris, editor, Extreme Value

Liquidity risk is something you need to think about as an investor... both for small caps and large caps.

Yesterday, I explained why even mega-cap stocks like Meta Platforms (META) have staged huge one-day falls in recent years. But this idea goes even further.

Liquidity can dry up for entire markets, sending dozens of stocks plummeting faster than you'd ever expect.

These two assertions make up two of the "10 Heresies of Finance" listed in Chapter 12 of mathematician Benoit Mandelbrot's must-read 2004 classic, The (Mis)Behavior of Markets. As Mandelbrot put it...

Markets Are Very, Very Risky ‒ More Risky Than the Standard Theories Imagine

Prices Often Leap, Not Glide. That Adds to the Risk.

Prices often leap... not glide. When it happens to entire markets, it can devastate your life savings for years.

And if you think it's impossible for it to happen again, you're mistaken...

The classic example of this is the one-day 22% drop in the Dow Jones Industrial Average that occurred on October 19, 1987... sometimes referred to as Black Monday.

When a market is in freefall like that, it means there aren't enough bids for the many shares being offered for sale, pushing the balance between the supply of shares offered and the demand for those shares ever lower.

If you try to sell into such a market, you might find it difficult to get limit orders filled. Selling with a limit order means you set a price that you won't sell below. But in these cases, the market will keep moving down while you're entering your order...

If it moves fast enough, your limit will never be reached. And if you use market orders – which execute as quickly as possible at current prices – you will lock in much bigger losses than you anticipated as prices spiral out of control...

When the market is in freefall, it's very difficult to execute transactions at any given price level... no matter the cause of the event.

The most recent example of an entire market in freefall was the Russian stock market...

The MOEX index represents Russia's 50 largest, most liquid stocks... the kind you'd think would resist liquidity risk. But when Russia invaded Ukraine last February, this market entered a liquidity crunch as investors rushed to sell.

The index fell 44% in just five trading sessions. Take a look at this chart below...

It's hard to miss the downward gaps. Again, as we covered yesterday, the gaps represent zero liquidity – no bids – between the closing and subsequent opening prices.

Perhaps you object on the grounds that Russia's whole stock market is worth just $700 billion today... with a peak value of about $913 billion in October 2021, according to data compiled by Bloomberg.

It's in the same market-cap ballpark as the Meta Platforms example that we shared yesterday.

Yes, it's in the same general market-cap range... but the MOEX contains the 50 largest companies in the most populous country in Europe.

The index does not contain just one company's share price, which has recently fallen due to information specific to that business... No, the MOEX contains the share prices of 50 companies, which are responding to an event not specific to their businesses and far outside their control.

The Russian invasion cuts into every aspect of the entire country... and it affects the (mostly foreign) investors who own the stocks in the MOEX Index.

But the broader point is this... It's foolish to believe something similar can't play out in the S&P 500 Index in the exact same way. During my lifetime, we've witnessed the single biggest downward price leap in history: Black Monday, October 19, 1987.

I believe it can happen again... which is in direct contradiction to what market professionals will swear is an absolute impossibility today.

They'll tell you that the stock exchanges today have circuit breakers. If the S&P 500 falls 20% in one day, gatekeepers automatically close the exchange. So there's no chance we'll see another Black Monday... Or so they say.

Humans have far less control of markets than they pretend to. Market moves are the result of countless unfathomable human interactions. Nobody truly masters them. The only thing you can do is learn to live with them.

The bottom line is, public-securities markets are risky... Those big, instant price leaps are normal.

With this in mind, one of the most useful things you can do is simply keep enough of your assets in cash... and perhaps precious metals, too.

Then, when the inevitable massive market dislocation arrives, you are both unharmed by the worst of it and ready to exploit it to the fullest.

If you're a regular reader and you've taken my consistent advice over the years to hold plenty of cash and plenty of gold and silver, the unpleasantness in the market last year hasn't fazed you... Or at least, it has made less of a dent in your portfolio than if you weren't holding those assets.

That will allow you to wait more patiently for the massive opportunity that always lies on the other side of the worst market volatility... which you can then exploit for maximum gain.

Good investing,

Dan Ferris

Editor's note: Dan says a rare, specific economic setup is on the horizon... and it's one that most investors will be entirely unprepared for. That's why he recently teamed up with an industry legend to explain exactly what's happening... how it's going to play out... and how you can make money from this precise moment in time. If you missed Dan's message, click here to watch the replay.

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