What Will Bring Volume Back to the Equity Markets?

By: Lightspeed Trading

Equity market volumes have been plunging over the last few years and are currently at levels not seen since 2007. In many ways, the situation can still be traced to the fallout from the financial crisis. The meltdown led to a bloodletting on Wall Street, with large investment banks laying off a significant amount of staff. The financial sector remains weak, even in 2012, and layoffs continue around the world. A still gloomy environment on Wall Street is undoubtedly contributing to slack trading volumes. 

Even more important, however, has been the reaction of retail investors in the wake of the crisis. Individual investors own roughly 50% of all stocks, and they have been fleeing equities for years. In 2011, individual investors yanked cash from mutual funds for a fifth straight year. Undoubtedly, retail investors still have the devastation of the financial crisis in the back of their minds. Furthermore, there are numerous issues that are currently plaguing the equity markets which continue to impact sentiment. 

Many individual investors are rightly afraid that the European sovereign debt crisis, for which there appears to be few solutions, could trigger a meltdown which is on par, or even greater, than what occurred in 2008 and 2009. Unfortunately, the obstacles facing market sentiment go beyond just economic headwinds and general fear and uncertainty. 

The very integrity of U.S. market structure has increasingly come under scrutiny. The May 6, 2010 Flash Crash had a devastating impact on retail investor sentiment and many institutional traders have also bemoaned the seemingly increasing instability of the market structure. Arguably, one of the primary causes of this decrease in confidence is the rapid expansion of high-frequency and algorithmic trading as the primary source of equity volume. 

Little consensus has been reached with regard to these forms of high-speed trading which largely rely on technology infrastructure onlyavailable through select brokerage firms and servers co-located next to the exchanges. It seems certain, however, that some of the strategies being unleashed on the markets are predatory, while many others seem to be benign. The fact is, however, that the prevalence of high-frequency trading has created tremendous apprehension in the market. 

Furthermore, one of the primary arguments that supporters of high-frequency trading make, is that it provides much needed liquidity. Much of this liquidity, however, seems to be of the phantom variety. It is only provided when it is advantageous on the part of the high-frequency traders. During the Flash Crash, many of these market players simply pulled their liquidity and shut off their systems. 

A recent example of the continued instability that seems to be playing out at the market structure level occurred in early August when a rogue algorithm unleashed by Knight Capital KCG caused as many as 150 stocks to gyrate wildly for nearly 45 minutes after the opening bell. The glitch caused the firm to lose $440 million in less than an hour and almost sunk it into bankruptcy. 

As a result of events like these, many retail and institutional investors alike are simply taking their ball and going home after coming to the conclusion that the playing field is not only uneven, but increasingly unstable. Consider, for example, some of the hedge fund liquidations and retirements that have occurred in recent years. One has to wonder why this is happening. 

In August 2010, legendary manager Stanley Druckenmiller called it quits after his Duquesne hedge fund hit rocky times. Just this August, Louis Bacon, one of the most prominent hedge fund managers in the world, 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 or simply leaving the markets, but there are dozens more. 

Some of these factors could also be driving investors to flood into bond and fixed income instruments, which in and of itself, is an obvious cause of falling volumes in equities. Bonds have been in a bull market for over a decade. In large part, this rise is being driven by a massive, long-term re-allocation out of equities and into seemingly "safe" fixed income instruments. At some point, the consequences of what some are calling a "bond bubble" may be unleashed on global financial markets, but for now bonds continue to rise, thereby drawing even more investors. The entire market appears to be a self-fulfilling prophecy -- until, of course it isn't.

Another factor that is driving falling equity volumes is a lack of volatility. The market moves and volatility levels that were seen in 2008 and 2009 were so extreme, that it only makes sense that they would be followed by a low-volatility "corrective phase," so to speak. While we have seen some sharp volatility spikes, accompanied by heavy volume in short time frames, the general trend has been for low volatility. If that were to change dramatically, it would almost certainly be accompanied by a big surge in volume. 

Eventually, this will happen and it will likely be triggered by some sort of dramatic macroeconomic event. Right now, there is little evidence that volume will return if markets continue to gently rise. A less likely scenario would be that the global economy improves dramatically and continued loose monetary policy pushes investors heavily back into stocks. 

While the future of the macroeconomic landscape may be uncertain, any efforts which could be taken to assure investors of the basic integrity and stability of the capital markets would be of immediate benefit. No matter what happens, it is unlikely that the trend of falling volumes will reverse without trust and transparency in the entire investment process being strengthened market-wide.