Low Stock Market Volume - It’s Even Weaker Than You Think

8/9/2019 Low Stock Market Volume - Its Even Weaker Than You Think

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April 15, 2010

Low Stock Market Volume: Its Even Weaker

Than You Think[Editor's Note: U.S. stocks advanced for the fifth day in a row yesterday (Wednesday), with the

Standard & Poor's 500 closing above the 1,200 level for the first time in more than 18 months.

Traders cited growing confidence in the U.S. rebound as a key catalyst. But could stocks be

vulnerable? Contributing Editor Shah Gilani spotlights a risk that traders are overlooking.]

By Shah Gilani, Contributing Editor, Money Morning

Conventional investing wisdomtells usthatwhenstocks rally on low stockmarket

volume, traders perceivethat lackofwidespread participationasan indicator ofthe

market'sfuturevulnerability.

Andastorridasthis rally in U.S. stock priceshasbeen, the lackoftradingvolumehas

beenaconsistentcausefor concern.

Unfortunately for marketbulls, eventhis well-chronicledconcerndoesn'ttell the whole

story. That'sbecause U.S. stockmarketvolume iseven worse - actually, much worse -

thananyone realizes. Andthis ultra-low stockmarketvolumeshouldbesending up

someserious redflagsfor investors.

Pump Up the Volume ...

Other thanactual stock prices, tradingvolume isoneofthemostclosely watched

measuresofstock-markethealth. Volume isbothanumber - ameasureofmarket

liquidity basedonthenumber ofsharesthatchangehandseachday - andan indicator

- demonstrating justhow muchconfidencetradershave (or don'thave) ina particular

markettrend.

Larger-than-normal volume isviewedasasignthattradersareconfident inthemarket

trendathand. Movementon low volume isseenasan indicator ofatrendthat's

unlikely tocontinue.

That's why - despitethenear-record run-up thatU.S. stockshaveenjoyedfromtheir

March 9, 2009 post-financial-crisisstockmarket lows - the lightvolumethat's

accompaniedthismovehasbeenso irksometo investors.


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Unfortunately, the perception ismuchbetter thanthe reality. Andthankstothreekey

factors - high-frequency trading (HFT), the proliferation of exchange-traded

funds (ETFs)andactive-arbitrage trading - current stock-market volume is far

worse than investors even imagine.

High-frequency trading (HFT)conductedby proprietary tradingdesksatbigbanksand

privatehedgefundsaccountedfor 70% ofequity tradingvolume in 2009, accordingto

a paper released lastmonthby theFederal Reserve BankofChicago.

Themassive proliferationofexchange-tradedfunds (ETFs)thathavebecomeso

popular with retail investors isalsoamajor causeofthemisleadingstock-market

volumestatistics. Andnotbecausethey aretradedby investors, butbecausethey are

tradedby ahandful ofprivileged "INSIDERS."

Inadditionto HFT sharevolume, activearbitragetradingby "authorized participants"

increasesdaily volume whenthese insidersbuy andsell the underlyingsecuritiesthat

make up ETF portfoliosagainsttheir simultaneoustradingoftheactual ETF shares.

How theseactivetraders increasevolumeand whatthatmeansfor markets is

important.

They Don't Call it 'High Frequency Investing'

High-frequency trading isnot investing. HFT incorporatesmathematically driven

algorithmsthatpromptpowerful computer systemsto lookfor statistical patternsand

pricinganomaliesby scanningthevariousstockexchangesandalternativetrading

networks.

Whenanopportunity arisesto profitfrom whatpractitionersofthese incredibly

profitablestrategiescall "statistical arbitrage," tradersemploy massive leverageand

executetheir tradesby usingsuper-fastcomputers. Typically, thesetradesareexecuted

innano-seconds (billionthsofasecond)andtheopportunitiescanbeover justthatquickly, or may lastfor minutesor hours. Lessfrequently, someofthesetypesoftrades

areheldfor afew days, or longer.

TABB Group, afinancial-markets researchfirm, saysthathigh-frequency trading

accountsfor 73% ofall equity trading, up from 30% four yearsago.


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Still, tradevolumeonthe New York Stock Exchange is 25% lower this year than itwas

atthissame point lastyear. The 200-day movingaverage isnow at1.2 billionsharesa

day, downfrom 1.6 billion, accordingtoThe Associated Press.

Asanemicasthatsounds, the reality isactually evenmoredour: Ofthe 1.2 billionsharestraded per day, 876,000,000 shareschangehandsbecauseofshort-termtrades

executedby "statarbs" (statistical arbitrageurs)- andnotbecauseof investors.

Membersofthestat-arbcrowdarguethatthey provide increased liquidity tothe

marketsas willingbuyersandsellers, comparingthemselvesandthe rolethey play to

thatofmarket-makersandspecialists. And whiletherearesomesimilarities, thebottom

line isthatstatarbsarenotmarket-makersanddonothavethesamefiduciary dutyas

market-makersandspecialistsdo, which isto "keep fair andorderly markets."

ThevolumethatHFT strategiesgenerate is problematiconthreefronts:

y Itaddsexponentially todaily volume, whichmasks whattrue liquidity mightbeinanother panicsell-off.

y Thesheer volumeofthe institutional HFT activity createsa potential nightmarescenario, shouldhumanerror or acomputer breakdown unleashatorrentof

backwardstrades.y Finally, inadditiontohumanfrailty anda potential "ghost-in-the-machine

scenario," amultiplier getsaddedtotheblind-alley concerns, sincemany ofthesehighly leveragedfirmsanddesksareonthesamesideofmany ofthe

sametrades.

There'sa lotmoretoaddress regarding HFT - and whattheChicago Fedandthe

Securitiesand ExchangeCommission (SEC)areconcernedabout - butthescopeofthis

articleconcerns HFT and its impactonvolume.

Theother major contributor todaily volume isacousinofthehighfrequency school of

tradingstrategies. Only, while you may havebeenawareofHFT, you probably aren't

awareofwhotheseother insidersareand whatthey doonadaily basis.

I'mtalkingaboutexchange-tradedfunds.

The Underside of ETFs

Exchange-tradedfundshaveexploded inbothnumber and use. Their total issuance is

fastapproaching $1 trillion. They come inall shapesandsizesandoffer daily-stock-


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markettradingand liquidity. The underlying portfolios, indexes, benchmarks, stylesand

assetclassesoffer exposuretocornersoftheglobal financial marketsthattraditional

retail investorsnever beforehadaccessto.

Inshort, ETFsarebothan investing phenomenonandafinancial juggernaut.

Whatmost investorsdon'tknow isthatexchange-tradedfundsarealsodesignedto

generateconventional-tradingand risk-free-arbitrage profitsfor the insiders whoactas

custodiansofthe ETF unitsthey create.

Thesponsor ofan ETF usually engagesabank, brokeragehouse, investmentfirmor

market-maker tobecomean "authorized participant" whose job isto "create" the units

thatwill becomethe "shares" ofthe ETF. Ofcourse, Wall Streetbeing Wall Street, a

sponsor canhire itself - or anaffiliatedentity - tobe itsauthorized participant.

Inthecaseofequity ETFs, theauthorized participantgoes intothemarketandbuys

sharesofall thestocksthatwill serveasthe ETF's underlying portfolio. Insomecases,

futures, derivatives, customizedcontracts, or evensomeother typesoffinancial

instruments, are incorporated intothatmix, either inadditionto - or even in lieu of -

theactual underlyingstocks.

For purposesofsimplicity, we'll stick withthe pure-equity model tomakeour example

assimpleandasclear as possible.

Theauthorized participantdeliversthestocks itpurchasedtothesponsor, whodeposits

them withatrustee. In return, in what'sknownasan "in-kind" transaction, thesponsor

turnsaroundand providestheauthorized participantwith "creation units." Creation

unitsareblocksofbetween 10,000 and 600,000 sharesofthenewly minted ETF.

Whena retail investor purchasessharesofthisnewly minted ETF, theauthorized

participantdeliversthemtothe investor'sbroker. Oncesharesaredeliveredtothefirst

buyer, anytimethatan ETF shareholder wantstosell hisshares, the process isthe

sameas ifhe weremerely sellingaconventional stock - throughhisbroker andthroughthecorrespondingexchange wherethesecuritiesaretraded.

For theauthorized participant, here'sthe really greatpoint: They arefreetotradethe

actual ETF sharesthatthey helpedcreate - as well asany andall ofthe underlying

stocksthatmake up thatETF.


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Infact, these institutional playerstradethembothsimultaneously andextensively. It's

avery pureformofarbitrage. Arbitrage isessentially thesimultaneoustradingoftwo

similar (or identical)financial instruments. Theobjective: Tomakea risk-free profit

fromadifference in prices.

Thesimplestexampleofanarbitrage wouldbe ifyou couldbuy XYZ sharesonthe Big

Board in New Yorkfor $40 each, whilesimultaneously selling thevery samenumber of

XYZ sharesonanother exchange (say, Philadelphiaor London)for $40.25 each. You

would pocketa risk-free profitof25 centsoneachshare. Thatmay notsound like

much, but imaginedoingthatseveral timesaday, duringeachtradingday ofthe year,

andtothetuneofamillionsharesfor eachtransaction!

Authorized participantsexecutetheir ownformofarbitrage: They buy andsell ETF

sharesontheexchangesandsimultaneously buy andsell all the underlyingsharesof

thestocksthatmake up the ETF tracking portfolios. They make risk-free profitsby

conductingthisarbitrage whenthe pricesofthe ETF sharesdonotprecisely correspond

withthevalueofthe underlying portfolioofstocks.

Froma pricingstandpoint, this isavery goodthing: Itservestokeep thenet-asset

value (NAV)ofan ETF in line withthevalueofthe underlying portfolioofstocksthat

the ETF represents.

Butfromavolumestandpoint, thisspecializedtradingcreatesafalsemarketplace

perception: Itartificially elevatestheshare-tradingvolume inboththe ETFsand inall

their underlyingstocks.

Protecting Yourself From the Weak-Volume Fallout

Tothis point, I havebeen unabletofindany specific, publically availablestatisticson

how muchshare-tradingvolumethisarbitragecreates. Restassured, however, thatthe

additional amount ishugeandthat - as isthecase with HFT - it isnot investment-

relatedtradingvolume. It isvery-short-termtradingvolume. And itaddsconsiderably

tothedaily market-volumetally.

Theneteffectofarbitragetrading (high-frequency tradersalsoexecutearbitragetrades

in ETFs, incompetition withauthorized participants) isthat investmentvolume is

considerably lower than investors perceive ittobe.

Noneofthismattersmuchas longas pricesare rising, whichwe'vesaidcould


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potentially continuefor sometimetocome. But ifU.S. stocksdocorrect, there'savery

goodchancethattheneteffectmay be less liquidity onthe way downthanthere ison

themoreorderly way up.

Andthatcouldsharply steepenany decline.

Whether or nottheconventional wisdom - thatmarketsthatrally onthinvolumeare

dangerous - will be provencorrectby any meaningful downturn remainstobeseen. But

I'mnotonetofloutsuch wisdomoutofhand - especially ifthere'sasimpleand low-

costway ofprotectingmyselfagainstsucha possibility. I recommend that investors

take prudent measures by maintaining stop-loss orders that can protect

them if this low-volume environment happens to result in a steep sell-off.

[Editor's Note: This essay demonstrates yet again of how investors can use

the powerful financial trends known as "capital waves" to help them shape

their investing strategies. It's a premise that Money Morning Contributing

Editor R. Shah Gilani has shared with readers time and again. And it's an

investing approach that's allowed Gilani to correctly anticipate some of the

biggest events that occurred during the ongoing global financial crisis.

A retired hedge-fund manager and gifted analyst, Gilani regularly takes

readers behind Wall Street's "velvet rope" - and into the world he knows so

well - exposing the pitfalls that can inoculate investors against ruinous losses

even as he highlights profit opportunities that most other experts never even

recognize.

It's no surprise that Gilani's essays have been read by millions.

With his new advisory service - The Capital Wave Forecast - Gilani shows

investors the monster "capital waves" now forming, will demonstrate how to

profit from every one, and will make sure to highlight the market pitfalls that

all too often sweep investors away.

Take a moment to check out Gilani's capital-wave-investing strategy - and

the profit opportunities that he's watching as a result. And take a look at

some of his most-recent essays, which are available free of charge. To read

one of his most-popular essays, please click here.]


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Low Stock Market Volume - It’s Even Weaker Than You Think