Trading Volume at 4-Year Lows: Distrust? Regulation? Apathy?

As the markets have plunged over the past two days, one question is emerging: What has happened to trading volume?

On Tuesday, the Drudge Report dubbed the phenomenon as being a "Wall Street ghost town". CNBC's John Melloy has called it "one of the biggest mysteries on Wall Street. How can stocks be in their fourth year of a bull market and trading activity be so low?" Per Melloy's analysis, traders may be favoring alternative asset classes over equities. Options and futures markets may be becoming more popular.

According to TradeMonster.com's Pete Najarian, "The options market has been breaking records for nine straight years and the shift has been a growing field that provides protection and leverage." Interestingly, Credit Suisse analyst Ana Avramovic commented that "high-frequency trading, which accounts for half of all market activity, has been on the decline since last summer."

Melloy suggested in his analysis that trading volume may be low because "the average investor simply doesn't trust this market anymore." Doug Kass: "There is no fresh money going into the markets. Why should we be surprised the retail investor is not there? We've had two huge drawdowns in stocks since 2000, a flash crash two years ago and real incomes are stagnating."

An alternate idea is that financial regulation is to blame for low volume in that regulation "has restricted trading activity by the major banks." One could argue that the more the government regulates something, the less of that thing there is. On the other hand, one could contend that banks should be held responsible owing to their part in the causing the Great Recession. On this line of thought, the Crosscurrents financial newsletter author Alan Newman commented, "The financial industry has placed itself above the investing public ('muppets') and will take every advantage it can secure. The public's confidence has been shattered, possibly beyond repair."

It is interesting to note that in January 2012, TheStreet.com's Robert Holmes suggested that a mass exodus from the stock market may be coming. Of course, at that time Holmes was writing in the context of a possible 20 percent drop in the stock market that could potentially bring about a fall in investor confidence, a rise in political uncertainty, a rise in unemployment, and more central bank intervention. Holmes: "For investors, another collapse in 2012 could mean that many throw in the towel on the stock market" thereby potentially causing a "generational change in investing and spending habits."

In light of the above discussion, the decline in trading volume could be owing to a blend of distrust, regulation, apathy, and perhaps a bit of thrift. In taking into account the implementation of the "Volcker Rule", scheduled to take effect on July 21, 2012, liquidity and volume could further decline. According to Reuters, "The Volcker rule, named for former Fed Chairman Paul Volcker who championed the measure, aims to prevent banks from making risky trades by prohibiting short-term trading for their own profit in securities, derivatives and other financial products. It will also prohibit banks from investing in, or sponsoring, hedge funds or private equity funds." With less liquidity for equities with a ban on proprietary trading by commercial banks, one has to wonder if the Volcker Rule could somehow lead affected banks to more so embrace the foreign exchange markets and other accessible asset classes.

Another dimension to the issue of low trading volume could be a general societal skepticism toward the stock market. Perhaps investors and traders are leaning more toward a "lazy portfolio" buy and hold strategy. MarketWatch's Paul Farrell has previously commented, "The more you trade at Wall Street's casino, the richer your broker gets." From this perspective, a buy and hold strategy can be advantageous; investing should be boring and dull -- like "watching paint dry or watching grass grow." Aside from affecting trading volume, the perception that Wall Street is merely a casino could be affecting demand for precious metals as well; so goes the cliche, "gold has never been worth zero." In December 2011, I explored the analogy of the stock market being like a casino. At that time, I noted that "if the world were to act like a casino, rational players would refuse to play." On the topic of equities remaining a viable avenue for investment, I discussed that "if individuals and firms stop investing in stocks, then we will all be at a loss."

That being said, societal skepticism toward the stock market is only compounded by the perception that algorithmic trading has left human investors at a disadvantage as individual consumers are left to deal with less disposable income owing to rising food and fuel costs. The 2008 financial crisis seems to have compromised the delicate tripartite balance between Washington, Wall Street, and Main Street. And less disposable income for the consumer means less discretionary funds left over for investment in things like stocks, bonds, and precious metals.

This line of discussion brings to mind Graham Summers' recent commentary on Zero Hedge that as capitalism has been undermined since the financial crisis began in 2008, we will not have any real recovery until trust is restored in the financial system. From this perspective, perhaps a decline in trading volume reveals a subtle decline in trust within the financial system. Then again, in light of low trading volume, if distrust of the financial system is rising, how sure can we be that we are in fact in the fourth year of a bull market?