"Trading Volume - What Can it Teach Us?"

Sydney M. Williams

Thought of the Day

“Trading Volume – What Can it Teach Us?”

July 29, 2010

The S&P 500 is 8.5% higher than it was on July 2, making for a pretty decent month after a devastating May and June. However, enthusiasm for the rally has been tempered by a lack of volume supporting the move. Eyeballing the charts for both NYSE and consolidated tape volume, it appears that the former is down about 20% and the latter 30% in July versus the two preceding months.

Volume though, as a determination of investor confidence, has become increasingly difficult to measure, a problem one can attribute to the proliferation of algorithmic traders, especially those utilizing high frequency trading platforms. While no one seems to know exactly, estimates have been that such traders represent up to 70% of all trading volume. Most of their trading is done via electronic exchanges (ECNs), so is included in the consolidated numbers. A friend who manages portfolios that exclusively use ETFs tells me that only 15% to 20% of his trades are executed on the NYSE. As an indication of the growing popularity of the consolidated tape, volume has risen from twice that of the NYSE in June 2007 to between four and five times at present.

Supporters of algorithmic traders claim they have replaced traditional market makers, as principal providers of liquidity, that they narrow spreads and reduce costs. Opponents, a group to which I belong, argue that liquidity disappears just when it is needed. In crowded trades, when something goes wrong, the exits get mobbed, as we saw on May 6 and the “flash crash”. It is hard to believe that someone who is trading for fractions of a penny and holding their positions for eleven seconds serves society, let alone other investors or corporate managements. Stock certificates, which represent ownership in a business, have been replaced by chips more appropriate in a casino. I find myself agreeing with the wag who said HFTs provide volume, not liquidity.

For the past twelve weeks the SEC has been “investigating” the causes of the “flash crash”, an incident that undoubtedly was caused (or aggravated) by high frequency traders. Volume that day, at 10.727 billion shares, was more than twice the average trading volume. Markets just don’t decline 1000 points, and then recover 600 points, for no fundamental reason. While the SEC seems to be studiously avoiding having to come to a conclusion, Congress passed, and the President signed, a financial reform bill that includes the establishment of a “consumer protection board” with a $600 million budget and unprecedented powers. Rather than creating new “Czars”, the people would have been better served if Congress simply ensured that existing regulatory agencies did their job. As the SEC fiddles, confidence in our markets ebbs.

According to research done by Jeff Rubin, director of research at Birinyi Associates, a proliferation of Index Funds and ETFs, another source of rising volume trends, have created a situation where correlation among individual equities has increased, reducing the dispersion of returns, making it tougher for traditional stock pickers. Arguably, those very inefficiencies should produce pricing opportunities for fundamental investors. But, at this point the magnitude of algorithmic high frequency trading programs simply overwhelm those done by fundamental investors. It is a case of the tail wagging the dog.

Public companies, in fact our capitalist society, rely on fundamentally-driven equity investors. Long term investors (which include passive investors, such as broad based Index Funds) lend an element of stability to the capital structure of companies. Additionally, active investors and knowledgeable analysts provide guidance to management and serve as watch dogs, with short sellers, among others, alerting the Street as to possible pitfalls or misdeeds. At this time, while quantitative traders of all stripes represent the bulk of trading activity, they manage only a small portion of equity assets. Nevertheless, it is surprising, as a friend and former specialist pointed out recently, that corporate managers seem to express little concern about the commoditization of our markets.

Index products, ETFs and various algorithmic trading platforms, especially high frequency traders, have juiced volume, thereby providing the specter of healthy capital markets, but they risk undermining those markets.

Fiscal policy can be employed to encourage long term investing and discourage very short term trading, but it requires a radical change in the tax code – for example eliminating capital gains taxes on investments held more than five years, while imposing stiff taxes on trades held for less than a day. The SEC needs to demonstrate that it is truly interested in protecting the interests of fundamental investors, those who provide the needed capital to businesses which employ most of our workers. Major Wall Street firms, which derive a substantial percentage of their profits from trading and are major donors to both political parties, are resisting these changes. The Dodd-Frank Bill appears to have done very little to reduce their playing fields. If these trends persist we all risk further alienating individual investors, the life blood of our capitalist system. Big volume days are no panacea; in fact they may be indicative of the problem.