April 15, 2010

Low Stock Market Volume: It’s Even Weaker

Than You Think
[Editor's Note: U.S. stocks advanced for the fifth day in a row yesterday (Wednesday), with the
Standard & Poor's 500 closing above the 1,200 level for the first time in more than 18 months.
Traders cited growing confidence in the U.S. rebound as a key catalyst. But could stocks be
vulnerable? Contributing Editor Shah Gilani spotlights a risk that traders are overlooking.]

By Shah Gilani, Contributing Editor, Money Morning

Conventional investing wisdom tells us that when stocks rally on low stock market
volume, traders perceive that lack of widespread participation as an indicator of the
market's future vulnerability.

And as torrid as this rally in U.S. stock prices has been, the lack of trading volume has
been a consistent cause for concern.

Unfortunately for market bulls, even this well-chronicled concern doesn't tell the whole
story. That's because U.S. stock market volume is even worse - actually, much worse -
than anyone realizes. And this ultra-low stock market volume should be sending up
some serious red flags for investors.

Pump Up the Volume ...

Other than actual stock prices, trading volume is one of the most closely watched
measures of stock-market health. Volume is both a number - a measure of market
liquidity based on the number of shares that change hands each day - and an indicator
- demonstrating just how much confidence traders have (or don't have) in a particular
market trend.

Larger-than-normal volume is viewed as a sign that traders are confident in the market
trend at hand. Movement on low volume is seen as an indicator of a trend that's
unlikely to continue.

That's why - despite the near-record run-up that U.S. stocks have enjoyed from their
March 9, 2009 post-financial-crisis stock market lows - the light volume that's
accompanied this move has been so irksome to investors.
Unfortunately, the perception is much better than the reality. And thanks to three key
factors - high-frequency trading (HFT), the proliferation of exchange-traded
funds (ETFs) and active-arbitrage trading - current stock-market volume is far
worse than investors even imagine.

High-frequency trading (HFT) conducted by proprietary trading desks at big banks and
private hedge funds accounted for 70% of equity trading volume in 2009, according to
a paper released last month by the Federal Reserve Bank of Chicago.

The massive proliferation of exchange-traded funds (ETFs) that have become so

popular with retail investors is also a major cause of the misleading stock-market
volume statistics. And not because they are traded by investors, but because they are
traded by a handful of privileged "INSIDERS."

In addition to HFT share volume, active arbitrage trading by "authorized participants"

increases daily volume when these insiders buy and sell the underlying securities that
make up ETF portfolios against their simultaneous trading of the actual ETF shares.

How these active traders increase volume and what that means for markets is
important.

They Don't Call it 'High Frequency Investing'

High-frequency trading is not investing. HFT incorporates mathematically driven

algorithms that prompt powerful computer systems to look for statistical patterns and
pricing anomalies by scanning the various stock exchanges and alternative trading
networks.

When an opportunity arises to profit from what practitioners of these incredibly

profitable strategies call "statistical arbitrage," traders employ massive leverage and
execute their trades by using super-fast computers. Typically, these trades are
executed in nano-seconds (billionths of a second) and the opportunities can be over
just that quickly, or may last for minutes or hours. Less frequently, some of these types
of trades are held for a few days, or longer.

TABB Group, a financial-markets research firm, says that high-frequency trading

accounts for 73% of all equity trading, up from 30% four years ago.
Still, trade volume on the New York Stock Exchange is 25% lower this year than it was
at this same point last year. The 200-day moving average is now at 1.2 billion shares a
day, down from 1.6 billion, according to The Associated Press.

As anemic as that sounds, the reality is actually even more dour: Of the 1.2 billion
shares traded per day, 876,000,000 shares change hands because of short-term trades
executed by "stat arbs" (statistical arbitrageurs)- and not because of investors.

Members of the stat-arb crowd argue that they provide increased liquidity to the
markets as willing buyers and sellers, comparing themselves and the role they play to
that of market-makers and specialists. And while there are some similarities, the bottom
line is that stat arbs are not market-makers and do not have the same fiduciary duty as
market-makers and specialists do, which is to "keep fair and orderly markets."

The volume that HFT strategies generate is problematic on three fronts:

 It adds exponentially to daily volume, which masks what true liquidity might be
in another panic sell-off.
 The sheer volume of the institutional HFT activity creates a potential nightmare
scenario, should human error or a computer breakdown unleash a torrent of
backwards trades.
 Finally, in addition to human frailty and a potential "ghost-in-the-machine
scenario," a multiplier gets added to the blind-alley concerns, since many of
these highly leveraged firms and desks are on the same side of many of the
same trades.

There's a lot more to address regarding HFT - and what the Chicago Fed and the
Securities and Exchange Commission (SEC) are concerned about - but the scope of this
article concerns HFT and its impact on volume.

The other major contributor to daily volume is a cousin of the high frequency school of
trading strategies. Only, while you may have been aware of HFT, you probably aren't
aware of who these other insiders are and what they do on a daily basis.

I'm talking about exchange-traded funds.

The Underside of ETFs

Exchange-traded funds have exploded in both number and use. Their total issuance is
fast approaching $1 trillion. They come in all shapes and sizes and offer daily-stock-
market trading and liquidity. The underlying portfolios, indexes, benchmarks, styles and
asset classes offer exposure to corners of the global financial markets that traditional
retail investors never before had access to.

In short, ETFs are both an investing phenomenon and a financial juggernaut.

What most investors don't know is that exchange-traded funds are also designed to
generate conventional-trading and risk-free-arbitrage profits for the insiders who act as
custodians of the ETF units they create.

The sponsor of an ETF usually engages a bank, brokerage house, investment firm or
market-maker to become an "authorized participant" whose job is to "create" the units
that will become the "shares" of the ETF. Of course, Wall Street being Wall Street, a
sponsor can hire itself - or an affiliated entity - to be its authorized participant.

In the case of equity ETFs, the authorized participant goes into the market and buys
shares of all the stocks that will serve as the ETF's underlying portfolio. In some cases,
futures, derivatives, customized contracts, or even some other types of financial
instruments, are incorporated into that mix, either in addition to - or even in lieu of -
the actual underlying stocks.

For purposes of simplicity, we'll stick with the pure-equity model to make our example
as simple and as clear as possible.

The authorized participant delivers the stocks it purchased to the sponsor, who deposits
them with a trustee. In return, in what's known as an "in-kind" transaction, the sponsor
turns around and provides the authorized participant with "creation units." Creation
units are blocks of between 10,000 and 600,000 shares of the newly minted ETF.

When a retail investor purchases shares of this newly minted ETF, the authorized
participant delivers them to the investor's broker. Once shares are delivered to the first
buyer, anytime that an ETF shareholder wants to sell his shares, the process is the
same as if he were merely selling a conventional stock - through his broker and through
the corresponding exchange where the securities are traded.

For the authorized participant, here's the really great point: They are free to trade the
actual ETF shares that they helped create - as well as any and all of the underlying
stocks that make up that ETF.
In fact, these institutional players trade them both simultaneously and extensively. It's
a very pure form of arbitrage. Arbitrage is essentially the simultaneous trading of two
similar (or identical) financial instruments. The objective: To make a risk-free profit
from a difference in prices.

The simplest example of an arbitrage would be if you could buy XYZ shares on the Big
Board in New York for $40 each, while simultaneously selling the very same number of
XYZ shares on another exchange (say, Philadelphia or London) for $40.25 each. You
would pocket a risk-free profit of 25 cents on each share. That may not sound like
much, but imagine doing that several times a day, during each trading day of the year,
and to the tune of a million shares for each transaction!

Authorized participants execute their own form of arbitrage: They buy and sell ETF
shares on the exchanges and simultaneously buy and sell all the underlying shares of
the stocks that make up the ETF tracking portfolios. They make risk-free profits by
conducting this arbitrage when the prices of the ETF shares do not precisely correspond
with the value of the underlying portfolio of stocks.

From a pricing standpoint, this is a very good thing: It serves to keep the net-asset
value (NAV) of an ETF in line with the value of the underlying portfolio of stocks that
the ETF represents.

But from a volume standpoint, this specialized trading creates a false marketplace
perception: It artificially elevates the share-trading volume in both the ETFs and in all
their underlying stocks.

Protecting Yourself From the Weak-Volume Fallout

To this point, I have been unable to find any specific, publically available statistics on
how much share-trading volume this arbitrage creates. Rest assured, however, that the
additional amount is huge and that - as is the case with HFT - it is not investment-
related trading volume. It is very-short-term trading volume. And it adds considerably
to the daily market-volume tally.

The net effect of arbitrage trading (high-frequency traders also execute arbitrage trades
in ETFs, in competition with authorized participants) is that investment volume is
considerably lower than investors perceive it to be.

None of this matters much as long as prices are rising, which we've said could
potentially continue for some time to come. But if U.S. stocks do correct, there's a very
good chance that the net effect may be less liquidity on the way down than there is on
the more orderly way up.

And that could sharply steepen any decline.

Whether or not the conventional wisdom - that markets that rally on thin volume are
dangerous - will be proven correct by any meaningful downturn remains to be seen. But
I'm not one to flout such wisdom out of hand - especially if there's a simple and low-
cost way of protecting myself against such a possibility. I recommend that investors
take prudent measures by maintaining stop-loss orders that can protect
them if this low-volume environment happens to result in a steep sell-off.

[Editor's Note: This essay demonstrates yet again of how investors can use
the powerful financial trends known as "capital waves" to help them shape
their investing strategies. It's a premise that Money Morning Contributing
Editor R. Shah Gilani has shared with readers time and again. And it's an
investing approach that's allowed Gilani to correctly anticipate some of the
biggest events that occurred during the ongoing global financial crisis.

A retired hedge-fund manager and gifted analyst, Gilani regularly takes

readers behind Wall Street's "velvet rope" - and into the world he knows so
well - exposing the pitfalls that can inoculate investors against ruinous losses
even as he highlights profit opportunities that most other experts never even
recognize.

It's no surprise that Gilani's essays have been read by millions.

With his new advisory service - The Capital Wave Forecast - Gilani shows
investors the monster "capital waves" now forming, will demonstrate how to
profit from every one, and will make sure to highlight the market pitfalls that
all too often sweep investors away.

Take a moment to check out Gilani's capital-wave-investing strategy - and

the profit opportunities that he's watching as a result. And take a look at
some of his most-recent essays, which are available free of charge. To read
one of his most-popular essays, please click here.]
 

 April 2, 2010

What’s Really Driving Obama’s Sudden Interest in Oil

 January 14, 2010

The Five Reasons Gold Will Hit $5,000

 December 28, 2009

Why Gold Will be the “Greatest Trade Ever”

 December 24, 2009

The Top Five Natural Gas Companies to Watch

 December 23, 2009

What the Government Isn’t Telling You About the New Healthcare Bill

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