Why Low Volume Isn't an Ominous Sign for Stock Market's Rally

NEW YORK ( TheStreet) -- That the  Standard & Poor's 500 Index's move above 2,000 was accompanied by low volume Tuesday may not be as ominous as many believe.

The PowerShares QQQ (QQQ) , SPDR Dow Jones Industrial Average (DIA) and SPDR S&P 500 (SPY)  moved to record levels this week on improving U.S. macro-economic data and talk of stimulus in Europe, finally. And this comes despite Russia apparently sending troops into Ukraine.


SPY Chart
SPY data by YCharts

One cautionary note, however, is that the move of U.S. equities to record highs has come on low volume, perhaps because investors may be reluctant to invest fresh capital at levels where valuations appear to be stretched.

The narrative has been the same for many months now: The economy is improving and corporate results remain steady, but investors are waiting on the sidelines.

The issue of low volume, though, appears to be a structural one. The chart below shows the average monthly volume of the S&P 500 from 1950 to the present day.

Average monthly trading volume in the S&P 500 remained relatively flat from 1950 until the turn of the millennium, when it grew exponentially before peaking in October 2008.

The growth of volume was the result of retail investors. Throughout the bull market of the 1990s and the tech frenzy that accompanied it, retail investors flocked to manage their own money in U.S. markets.

Data provided by  Yahoo Finance

This frenzy peaked in 2008, when the financial crisis hit and investors' portfolios dropped by 50% in less than two years. Since the crisis, trading volume has declined significantly.

Lightspeed Trading, an online broker, gives some reasons for the low trading volume.

One reason has to do with market integrity. The perceived decline in integrity of the U.S. market structure has prompted many investors to avoid the stock market.

The May 6, 2010 Flash Crash had a devastating impact on retail investor sentiment, and many institutional traders have said they fear the seemingly increasing instability of the market structure.

Similarly, the rapid expansion of high-frequency and algorithmic trading as the primary source of equity volume has frightened investors. The strategies implemented on markets by high-frequency firms are viewed as predatory, and the prevalence of high-frequency trading has created fear about market transparency.

Another factor is the difficulty in generating returns. In August 2010, legendary money manager Stanley Druckenmiller announced his retirement after his Duquesne hedge fund hit rocky times.

He was closely followed by Louis Bacon, a prominent hedge fund manager, who announced that his fund was returning 25% of its money back to investors, saying that "liquidity and opportunities have become more constrained."

The actions of these two investing legends are just two high-profile examples of top investors pulling back from or leaving the markets.

Another factor hurting the volume of equities trading is the popularity of fixed income. Some see the rush into bonds, leading to record low interest rates across the world, as a bubble that could pop. For now, however, bonds continue to rise alongside equities, thereby taking away from equity volume.

Still, U.S. equities continue to push higher. The chart below shows the inverse relationship from 2009 to present day of U.S. stock prices compared to its volume.

Data provided by Yahoo Finance

The trend signals that equities do not need volume to confirm moves higher. As the S&P 500 continues to push above 2000 on low volume, there is no ominous undertone, it is simply the new normal in U.S. markets.

 At the time of publication, the author held no positions in any of the funds mentioned.

Follow @macroinsights

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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