An important technical indicator that investors use to get a high conviction rate is volume. The more volume, the more likely the trend is reliable and likely to continue. Likewise, high volumes suggest greater liquidity, which is an important dimension of market health. One of the problems that equity markets have faced recently is low volume. Since 2009, volumes have been in decline with 2011 being particularly hard hit by declining trade volumes across markets.
More recently, bears criticized optimism for the 2012 bull market by pointing out that volumes have not improved. Bulls returned by saying that volumes are improving and are likely to increase in the future as greater confidence and lower volatility encourage retail investors to re-enter the market. This was even the premise of a recent New York Times article entitled “As Worries Ebb, Small Investors Propel the Markets.” Unfortunately, the article was thin on details.
Let’s Test the Hypothesis
Small investors prefer funds over individual stocks and increasingly invest in index funds. Index funds have also become more popular since 2008, when the market crash showed that stocks in individual companies can fall very deep very quickly even if their fundamentals are sound. Theoretically, this growing interest in index funds and the return of retail investors to the market should translate to robust growth for ETFs tracking indices.
Perhaps the most popular stock index fund is the SPDR S&P 500 ETF Trust (SPY), one of the oldest ETFs and one of the most inexpensive. While attrition from the fund thanks to low-cost alternatives such as Vanguard’s ETF is to be expected, SPY should still hold its own if enough retail investors are, as the Times says, propelling the markets.
SPY Volumes
So let’s take a look at SPY’s volumes and compare on a year-over-year basis:
For a bullish month and a half, SPY saw daily volumes of 143,672,829 on average for the beginning of 2012 in addition to price appreciation of 5%. That strong bull run should have encouraged more market participation on the buy side, especially the so-called “dumb money” following the trend. However, there is no consistent pattern in volumes; they appear more or less flat for the period (while we could do more sophisticated analysis of the numbers, we’ll keep things simple for this exercise).
Now let’s look at those numbers in 2013:
(2/8/13 is the last available data as of this writing.) Here we see average daily trading volumes for January of 125,765,485.2—a decline of 12.5%. That’s an enormous drop, and not good news for bulls. It also discredits the New York Times article, although our conviction rate must stay low as this is just one data point.
Double-Check with VOO
So let’s double check our results with VOO, one of the cheapest ETFs on the market from one of the most popular ETF issues and retail brokerages, Vanguard.
Here we see 4.94% price growth and volume averages of 416,317.857—the massive difference in volumes between this fund and SPY demonstrates just how important and popular SPDR remains. Now let’s see 2013’s results:
Here, 4.2% price growth is accompanied by average volumes of 1,739,048.15—growth of over 300%.
Well that’s different.
Interpreting the Results
Now the question is interpretation. The math is clear, but the trend is diverging; one way to account for this is that attrition from SPY towards cheaper alternatives is driving SPY’s customers away, and could cause a liquidity crisis if the trend continues. Likewise, the growth in VOO suggests that the market is seeing value in the fund’s lower cost.
More importantly for us now is the implications this has for trends in the retail investing world. If we simply added the 2012 and 2013 numbers together and compared, we’d see that total volume is still down by about 11.5%, simply because SPY’s volumes are so much bigger than VOO’s.
While Vanguard’s lower price is attracting more customers, which is great for Vanguard, it does not buck the overall trend of falling volumes. This suggests that the equity market, at least amongst retail investors is getting smaller—although it should be noted that several institutional investors buy ETFs too, so the falling volumes aren’t a very good indicator for the institutional side either.
Going forward, we will have to see whether this trend continues, and anyone building models for companies looking to curb systemic risk should consider how a shrinking equity marketplace is going to impact stock prices in the future, and how their portfolios are exposed accordingly. This doesn’t mean to jump ship, but it does mean to read the New York Times with a grain of salt.