Market Volume Is Rarely An Indicator Of Anything

by: Cullen Roche

There’s been a lot of ink spilled in recent years over the “low volume rally” in the equity markets. In case you don’t know, volume on the NYSE has declined pretty steadily throughout the rally in the equity market and some people take this to mean that the underlying rally lacks credibility. As if more volume automatically means more “conviction”. This implies that more heavily traded markets trade more efficiently than less heavily traded markets. Now, this might be true in an extreme sense. A thinly traded penny stock will probably trade less efficiently than a high volume member of the S&P 500 because its spread will be thinner. But that’s not what we’re comparing here. When people refer to the “low volume rally” they’re taking one of the most heavily traded indices in the world and comparing its relative historical volume. It’s not exactly the same as comparing the penny stock and the S&P 500 stock.

Anyhow, I think this arguments tends to run into several problems.

1) The “low volume rally” complaints tend to come from the same people who complain about high frequency trading. Well, which is it? Is high frequency trading good because it adds market liquidity? Isn’t complaining about a “low volume rally” and HFT a bit of a contradiction?

2) More importantly, high volume doesn’t necessarily mean markets are more rational. We often hear about the problems revolving around herding in markets. And that’s ultimately what high volume often amounts to. High volume is essentially a form of herding where a market becomes saturated due to the herding effect. And there’s nothing in herd mentality that implies a herd is more efficient than a smaller group of animals all running together. Yes, the herd MIGHT be more efficient, but history tends to show that the herd is often wrong and more of a sign of building inefficiency. This means low or high volume can often be a contrarian indicator!

The point is, low relative volume doesn’t necessarily tell us much about the quality of a market’s participants. In extreme cases I think market volume can tell us something about a market, but be wary about the mantra that “high volume = conviction” and “low volume = lack of conviction”. There’s more to the puzzle than that. A lot more.