“Equity Markets – Implications of Declining Volumes and Volatility”

Sydney M. Williams

Thought of the Day

“Equity Markets – Implications of Declining Volumes and Volatility”

March 14, 2012

Stocks have begun the year with one of the best performances in years. The S&P 500 is up 11.0%. Two factors have characterized this move. One has been a precipitous decline in volume (with the exception of yesterday, when most of the largest U.S. banks passed the latest round of “stress tests!”) and the second factor has been reduced volatility as measured by the VIX and as measured by days up or down more than 1.5 percent.

Monday’s volume in the NYSE, at 643.2 million shares was approximately 45% below the average for all of last year, while Composite volume, at 3.074 billion shares was about a third lower. Volume yesterday staged a major reversal, with NYSE volume at 906.1 million shares and Composite at 4.376 billion shares. The VIX closed at 15.64 on Monday, and 14.80 on Tuesday, the lowest level since April of last year. Thus far this year, on only three days has the daily volatility of the Dow Jones exceeded 1.5% – on the first trading day of the year, with that index up 179.82 points, last Wednesday, when the index retreated 203.66 points and yesterday when the DJIA rose 1.7 percent.

While declines in volumes have obvious, and negative, implications for brokers, it is unclear that such declines are injurious to investors. A declining VIX is almost always associated with improving markets. Birinyi Associates, in a piece out yesterday on volatility, confirms that finding.

Volume on both the New York Stock Exchange and Composite volume peaked with the credit crisis in October 2008 and have since been declining. In both cases volume is about 70% below what it was during that tumultuous period. Volume on the NYSE persists at about 25% of that on the Composite.

Explanations for declining volume are difficult to ascertain with any accuracy, but I suspect they encompass a few factors: Anecdotally, the attitude toward stocks appears, at best, lackadaisical; the Volcker rule has caused banks to eliminate, or shrink, their proprietary desks. Despite a market that has rallied 108% from its low in March 2009, equity mutual funds continue to get withdrawals; and the equity exposure of hedge funds seems abnormally low, as they await Armageddon – the consequences of a Federal Reserve printing its way toward safety. High frequency traders appear to be less active, slinking away, as a friend puts it, from the rocks under which they operate, as they watch the gradual approaching of SEC investigators.

It has been suggested that the decline in the VIX manifests a growing complacency. As the S&P 500 rallied 22% from its September 2011 lows, the VIX declined from 43 to its current level of 14.00. And, certainly if something came along to spook the market (and there are plenty of things that could), we would certainly see the VIX rebound. But, when one looks at a twenty-year chart of the VIX, it has spent more years at 20 or below than above. On December 19, 2006, I wrote a piece which began: “Complacency has settled over the financial markets like a soft coating of December snow.” At that time, the S&P 500 was 1425.55, up 80% over the previous three and a half years; the VIX was selling at 11.56 and had essentially been under 20 since October 2003. The high-yield market was on a tear and housing had already peaked. Now the VIX has been under twenty for two months. Equities, as mentioned, have rallied 22% over the past five and a half months and housing is showing signs, if not of recovery, of at least bottoming. Given the lack of equity exposure at hedge funds and the continued outflows from equity mutual funds, it doesn’t strike me that there is excess complacency in equity land. That doesn’t mean the market may not correct. It has never been known to behave as expected, but there is no bubble in equities.

Where there is complacency is in parts of the corporate market and in U.S. Treasuries. Yesterday Coca Cola sold a billion dollars of three-year notes with a 0.75% coupon, thirty-five basis points over Treasuries. With the Ten-Year yielding 2.1% and with the CPI over the last twelve months showing a gain of 2.9%, owners of Treasuries will, at some point, be in for a rude awakening. Could that disruption be felt by equity investors? Of course. But, in general, the balance sheets of non-financial corporations are in pretty good shape, and consumers, while recently increasing spending, are better off than they were a few years ago.

Over the past twenty years, a chart of the VIX shows five peaks: October 1997, during the Asian crisis; August 1998, when Russia defaulted; October 2002, when equity markets were bottoming following the internet-tech bubble, October 2008, at the height of the credit crisis (and when the VIX reached its all-time high of 89.53); and last October when the European crisis was at its height. But for most of the past twenty years the VIX has traded between 15 and 25. We are now below the low end, so it is certainly worth monitoring.

While declining volume certainly reflects factors unrelated to the relative valuation of stocks, one can reasonably assume that a market that rises on low volume is a market that has been missed by a number of participants – not, typical of a market that is extended. On the other hand, I do worry about the bubble that has developed in the Treasury market. When that bubble deflates, it will likely be sudden and will create unforeseen consequences. Investors are best off focusing on the valuation and prospects of the individual securities they are considering.