Stock market volume has been declining consistently since the May lows. It seems ironic to imply that risks are rising when fewer investors are buying and selling. In fact, the declining volume is directly raising the risk level. Because high frequency trading, a substantially recent phenomenon, now accounts for far more than half of daily trading volume, the retreat of traditional investors is dramatically understated.
For longer-term investment purposes, volume is smaller still when we recognize the changed profile of current market participants. Fundamental analysis is being overtaken by technical analysis, which typically has a far shorter time horizon. More and more transactions are placed by traders rather than investors. The “Flash Crash” on May 6, which saw the Dow Jones Industrials drop by 1000 points intraday, was striking evidence of the dangers of overwhelming volume on one side of a trade from which true investors have retreated.
Wall Street and the financial media that cater to it clearly reflect the changed orientation. Current comments debate “risk on” or “risk off” rather than valuation fundamentals, for example. When one watches financial television, we hear corporate earnings and revenue figures compared only with street expectations, which are absolutely irrelevant to long-term investors. They matter only to traders. We no longer hear year-over-year comparisons, which do provide helpful fundamental information. Financial TV would provide such data if investors were to demand it; but the producers are playing to their audience’s interests, which are far shorter-term.
There is nothing nefarious about the investment arena turning into a casino. It is important, however, for individual and institutional investors to recognize that this is no longer the traditional environment that has prevailed for decades. The players are motivated and influenced by many different factors from those that have been the prime influences on stock prices in the past. The investor’s traditional “buy and hold” approach, with which we have long disagreed, is a far riskier approach today than in decades past.
On a fundamental level, we have argued in many past writings and conferences that the current long weak cycle differs in both degree and specifics from most past cycles. The excesses built up in the 1980s and 1990s have yet to be purged. Rescue efforts to date have largely been an effort to prevent imminent catastrophe. Those efforts have been partially successful, but at what long-term cost? From an investor’s perspective, it is still unknown whether we can escape this cycle without solving the many problems that led to the financial crisis. The situation becomes more perilous by the long-term investor’s retreat , leaving the scene to traders whose approach is to flee from danger rather than hold stock through it. It is easy to see how almost everyone can quickly line up again on one side of a trade in an environment in which terrorism or physical or economic calamity could shake the world. More “Flash Crashes” are certainly possible.
We continue to encourage all investors to abandon traditional buy and hold, fixed asset allocation approaches and to adopt more flexible approaches based primarily on sound absolute, rather than relative, valuations.
Author's Disclosure: No Positions