by Elliot Turner
No matter which information venue one may turn to these days, it’s nearly impossible to miss the discussion about the lack of volume. Many question the legitimacy of any rally that comes with less volume than a preceding decline, and many others question the structure of today’s markets in light of the fact that in each of the last two years, market volume declined over the prior year. I take a slightly different approach. First, I think the decline in volume in equity markets is predominantly a good thing that portends more upside for the stock market, and second, I think different volume metrics provide a much clearer and more important snapshot of the state of our economy than equity market volume.
What Does Volume Mean Today?
Volume can be viewed through several different lenses. Volume can be stated in terms of quantity of transactions or the gross size of transactions. When people say “volume” it’s often with regard to the quantity of transactions, and in many ways that’s misleading in today’s market environment. Each day, for the most part, Citigroup (NYSE: C) is the most active trading stock in US equity markets, and each and every day, the gross quantity traded in that stock means little of anything for the overall market. It simply doesn’t matter. Yet it still counts in terms of overall market volume.
There are two significant factors further complicating an analysis of volume over the course of the last several years: first is the fact that US equity markets have undergone major structural changes, and second is the fact that we just experienced the single biggest shock to our financial system since the Great Depression. Both of these factors significantly and permanently altered the state of volume, and the fact that they happened somewhat in conjunction with each other makes it difficult to gauge how much of the larger effect has come from each.
As far as structural changes go, a funny thing happened on the way to global economic meltdown: prop desks who flipped stocks minutes at a time were replaced with computers who flip stocks by the second. Major institutions like Goldman Sachs (NYSE: GS) are closing down their prop desks, while their HFT shops continue to rake in the profits. Don’t believe all the rhetoric that this is solely a consequence of the Volcker Rule in the new financial regulations. A lot of that discussion is political grandstanding in the quest for more favorable compromises out of regulators. Prop desks enjoyed a great run in the midst of the epic volatility storm that wreaked havoc on our economy; however, in the storm’s wake, these desks have struggled mightily. In reality, this new transition has as much to do with the fact that proprietary trading takes on more risk and results in lower profits than the high frequency variety in today’s markets. At the end of the day, it’s simply good business to shift to HFT.
When Do We Get Volume These Days?
Let’s take a look at an SPY monthly chart for a quick visual:
Take note of WHEN exactly volume reaches its peaks. The larger, more substantial and scarier the decline, the more volume the market sees. That being said, do we really want to see volume confirm rallies? I mean, sure we want to see some sort of conviction to the upside, but is equity market volume the correct indicator? There is a clear connection between a surge in volume and a decline in equity markets.
There are several reasons for this relationship. On the way down, many with long equity exposure use market instruments to conduct their selling. It’s impossible to sell multi-billion baskets of stock easily, so these sellers turn to futures markets to hedge their long exposure with shorts. Next is the fact that when fear generates selling, selling is done for selling’s sake and people panic out. When the panic is done, those very same sellers don’t panic back into markets. They slowly and steadily accumulate individual positions which they like most. In that regard, it’s far more helpful to look for volume spikes in individual stocks than it is in the market at large, and those are plentiful in this September rally.
What Type of Volume Should Matter Most Right Now?
Well there is one volume indicator making significant highs: in both July and August, global M&A volume registered new monthly highs unseen since tracking began in 1995. In one week in August there was over $87 billion of M&A volume. This morning we woke up to the news that Unilver (NYSE: UN) would buy Alberto-Culver (NYSE: ACV) and Southwest Airlines (NYSE: LUV) would buy Airtran Airlines (NYSE: AAI). That trend will continue as companies look to deploy the cash hoarded during the crisis in a strategic manner.
M&A is not the only volume metric registering impressive results. The IPO market has looked particularly good lately, with innovative new companies looking to tap into public capital markets and venture capital firms looking to lighten up on positions bought in the time leading up to the financial crisis. This fall boasts an impressive lineup of IPOs that should awaken investors animal spirits. And just last week Petrobras (NYSE: PBR) priced the largest share offering in history–$67 billion.
These volume metrics mean far more than how many shares have flipped back and forth in the market indices and they generate far better quality in earnings for the financial system than do proprietary trading and HFT.
Disclosure: No relevant positions.