Small-cap liquidity is thinner than the index charts suggest

The index level tells you what things are worth. It tells you nothing about whether you could sell them. Those are separate questions and they have been diverging for about eighteen months.

The number I watch

Median daily dollar turnover for the bottom quintile of the small-cap universe, as a fraction of that quintile’s market capitalisation. It is a crude ratio and it has been falling steadily.

Six consecutive quarters down. The headline index has been perfectly respectable over the same window, which is exactly the problem: the chart that most people look at is dominated by the top of the distribution, where liquidity is fine.

Where this shows up

Three places, in the order you are likely to meet them. First, in the bid-ask you actually get filled at, which for names in that bottom quintile is now routinely several times the quoted spread on any order of size. Second, in fund flows: a small-cap fund facing redemptions sells its liquid names first, which leaves the fund progressively more concentrated in exactly the things it cannot sell. Third, in the gap risk around earnings, where a thin book and a surprise produce a move that has nothing to do with the magnitude of the news.

Liquidity is not a property of a stock. It is a property of a stock on a particular day, in a particular size, in a particular mood.

What I do about it

Nothing dramatic. I size positions in that part of the market at something I would be content to hold through a year of not being able to exit at a sensible price, which in practice means considerably smaller than the analysis alone would suggest. That is not a clever strategy. It is just taking the liquidity number seriously as an input rather than an afterthought.