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Happy trader on the New York Stock Exchange
Happy trader on the New York Stock Exchange

Market lab

The market's throwing a party, but few are going Add to ...

A funny thing happened on the way to the stock market recovery. Volumes forgot to come along.

While stock prices overall have come a long way from their trough in March, 2009, those gains have not been accompanied by a corresponding rise in trading volumes. Average volumes in both the U.S. and Canada have been trending downward throughout much of the recovery; U.S. volumes are at their lowest levels since 1999.

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That’s usually not the recipe for a sustainable rally. Traditionally, market watchers want to see volumes rise along with prices, a sign that growing demand is an underlying driver. Brockhouse Cooper global macro strategist Pierre Lapointe and financial economist Alex Bellefleur noted that the current rising-prices, falling-volumes trend is contrary to the past two economic cycles.

Yet after nearly two years of an upward-trending stock market, the lack of commitment on the volume side doesn’t seem to have posed much of an impediment. Something has changed that has created this disconnect between the price and volume trends.

ETFs may hold the answer

The routine explanation for the falling volumes is that after a decade of volatility and lacklustre returns, investors have been moving away from equities, in favour of bonds. But that doesn’t explain how a bull market can be sustained on fading volumes.

Mr. Lapointe and Mr. Bellefleur suggest that another trend that has emerged from the upheaval of recent years – the boom of exchange-traded funds – could partly explain this volume anomaly. That’s because indexed ETFs – the biggest and most popular funds in the sector –are, by their nature, low-activity funds that contribute relatively little trading volume.

“With ETFs, most of the stock purchases happen at the creation of the fund,” they wrote. “Post-IPO, trading is limited to rebalancing, marginal expansion of the fund and the volume in the ETF itself.”

That’s a big difference from the actively managed equity mutual funds that used to dominate retail investors’ portfolios. Those funds jump in and out of investments with considerably more regularity than ETFs – and that generates volume.

Volatility conundrum

ETFs still represent only about 17 per cent of U.S. mutual fund equity assets, but their rapid growth, combined with the outflow of investors from equity mutual funds, has certainly contributed to this declining volume trend. That market share for ETFs also suggests they have lots of room to grow– which could further subdue trading volumes.

And that, ironically, could actually fuel one of the market forces that drove investors toward ETFs in the first place: Volatility.

“Sluggish trading activity volumes have a sneaky effect: [Fewer]buyers and sellers means that market depth is small,” they wrote. “Getting in or out of a stock causes more price variation. This increases volatility.”

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