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This article is about the continuing market rally and why many are sitting it out. I want to discuss trading volume, but let me first emphasize another costly distraction for the individual investor.

In my preview for this week I pointed out that backward-looking valuation models were not helpful last year, nor will they be helpful in the near future. I made the mistake of not sufficiently highlighting one of my best articles from last year, where I explained how a fixation on the valuation argument would be costly for the individual investor. You can read it here. It covered all of the key questions, and it did so at exactly the time that would be most helpful for investors. Please read the comments as well, since the questions helped to spell out the story.

Is it now too late? Most people find it difficult to "chase" stocks that have made significant rallies. Think about this. The four-quarter forward earnings for the S&P 500 are now about $85 and the calendar year 2011 earnings are at $91 or so. If these estimates are accurate, even a conservative P/E multiple suggests that there is plenty of room to run. Or you could look deeply into the past...

Part of the reason that I quit writing about valuation -- and praised the Doug Kass approach last year -- is that there were so many strongly-held opinions about overall market valuation and earnings. People were locked into bad ideas. It is time to get out of that box.

I suggested thinking in terms of individual stocks. I currently have a long list of winners that still look cheap on projected earnings, and also many challengers on my watch list. When I see so many choices, the market is cheap.

The Volume Issue

There is a conspiracy theory about volume, that the low-volume rally implies some kind of market manipulation. As regular readers know, I regard conspiracy theories as uninformed, naive, and mistaken. Among Internet readers, most seem to think that these fringe sources have some kind of inside look. This provides an excellent opportunity to the much smaller readership here at "A Dash"!

Trying to summarize after a rather unhelpful discussion at RealMoney, Jim Cramer notes that several traditional indicators do not seem to have worked well in the last year. He wrote as follows:

We have had a rally since March of last year that seems totally unverified by volume. That means, to me, that volume just isn't useful right here, right now. That's no sin; lots of the important indicators of my career have been thwarted by this market. Last year the overbought/oversold oscillator didn't work at all -- the market went oversold and stayed oversold for weeks. If you bought in, you were crushed.

Brett Steenbarger, analyzing market moves and volume, has a typically level-headed, trader's assessment:

The result is a relatively low volume drift upward. I do not necessarily see this as a sign of complacency or as a sign of an imminent market downturn. Rather, I suspect that U.S. stocks are not seeing major capital flows, as traders and investors perceive greater global, macroeconomic opportunity elsewhere: in the perceived safety of high yields and the growth stories of emerging markets.

Some Little-Known Information

Somewhat to my surprise, there is little understanding or information about the impact of high-frequency algorithmic trading. I do not mean the conspiracy stuff; I mean what these companies really do. My information comes from well-placed sources, familiar with the trading methods, the personnel, and the actual programs. Here are a few facts:

  • For starters, most people do not know the names of the companies. They want to fly low.

  • Their trades make up over 70% of total volume, up from 30% a few years ago.

  • They have an exceptionally high proportion of winning trades, usually small trades in an inside market.

  • Their profits come from exceptionally small discrepancies in various markets, and moving swiftly to take advantage.

  • They can make money through rebates even when scratching a trade. These are liquidity providers.

  • They are more active on down days than up days. Why? There are more price discrepancies and therefore more opportunities to arbitrage.

  • The net effect of HFT is to reduce volatility by adding liquidity.

Conclusions

For the average trader there are three obvious conclusions:

  1. The volume data is no longer meaningful;

  2. There is a reason why volume is higher on down days;

  3. The price is what it is. These firms are not moving prices, but rather reducing volatility.

No firm is bigger than the market. If there is a great opportunity to adjust asset allocation by selling stocks and buying something else, someone will do it.

Anyone who suggests otherwise is leading you astray.

Source: The Connection Between Low Volume and High Frequency Trading