Saturday, June 7, 2014

Decrease in Stock Market Volume or Decrease in Brain Volume?

For the past few years, a bunch of articles have decried the ever-decreasing volume of the stock markets.  If they just stopped there, it would have been fine, but of course, everything always have to be tied up in a neat narrative.  Probably the most egregious offender is Josh Brown, who uses the decreasing volume as evidence of a "relentless bid."  Here is why he is wrong and everyone is dumb, except for me:

First, Brown's explanation of the relentless bid: 

It’s very simple – the wirehouse firms, which control 50% of all invested household wealth in America, have successfully pushed the majority of their advisors’ practices toward more hands-off investing approaches. At the same time, do-it-yourselfers have made Vanguard, State Street and BlackRock’s iShares three of the world’s largest asset managers – and they are primarily purveyors of passive indexing products.
No one is picking stocks, no one is doing much trading. That kind of activity has largely moved itself to the options markets, if anything. 
Most of the daily activity you see is the creation-redemption process taking place as money is allocated toward ETFs from people who aren’t even paying attention anymore. Hence, the Relentless Bid.

Fair enough hypothesis, that the low volatility and low volume is due to more and more market participants becoming passive asset allocators rather than active trading cowboys.   To show the low volume, he uses a generic chart from WSJ:


Just to confirm we were all on the same page, I got a volume chart for good ole' SPY:

So far so good, but does decreasing volume mean decrease in trading activity or liquidity?  Seems obvious, but the answer is not necessarily.  Consider you were trying to rank a universe of stocks from most liquid, ie most actively traded, to least liquid.  You come across BRK.A, which trades at $192,895/share (not a typo) and then you find FTR, which trades at $5.68/share.  If you check their volume, FTR seems way more liquid than BRK.A:


But there is a voice in your head that reminds you how stupid that sounds.  FTR is a single digit stock while 1 share of BRK.A can buy a house.  That's because the number of shares traded does not matter when we talk about liquidity.  We don't care about volume--we care about dollar volume, in essence, how many dollars changed hands, not shares.  No responsible market participant divides up their portfolio by buying 25 shares of each company.  He does it by buying a certain percentage expressed in dollar terms.  If you try buying $1 million worth of FTR and $1 million worth of BRK.A, there is no difference in liquidity:



For both, on average, $1-2 billion change hands every month.  So back to SPY: what happens when we start talking about dollars changing hands rather than shares changing hands?


Note the 50 month moving average.  It's staying flat and no longer trending down as the original chart misleadingly showed.  So yes, the number of shares traded has decreased, but that is due to each share being worth more and thus traders no longer needing to buy that many shares to satisfy their portfolios.  Therefore, there is no decrease in liquidity and no trading slowdown.

But to be fair to Brown, he did not interpret this; rather he quoted a WSJ article:

Trading volume on the major U.S. exchanges last month tumbled to its lowest level for May since the financial crisis. A daily average of 5.7 billion shares changed hands, the least for the month since 2007, according to Credit Suisse Trading Strategy. 
The decline comes despite six record closes last month on the S&P 500, extending a trading slowdown that started after the financial crisis. Daily average U.S. stock-trading volume last year was down 37% from the peak hit in 2009, Credit Suisse data show.

First of all, you should know this article was shady when comparing current volume to the peak volume at a bear market bottom.  No shit it would be lower now.  Volume is always highest at peaks and troughs.  Yet my beef isn't with this shitty article, but rather why Brown embraced it without realizing how misleading this whole charade is.  In fact, he wrote a whole book telling the audience not to trust wall street and here he is taking Wall Street Journal at face value.

The reason is simple because it's the same few reasons every time.  In this case, he already had his relentless bid thesis (it's actually a pretty good theory) and found an authority figure that bolsters this thesis.  Never mind that literally five minutes of fact checking would have uncovered the article's wobbly foundations, but this is why so many of us suck at this game, whether we are complete neophytes or been playing for decades.

Now use this lesson when actual money is on the line.  You have a great thesis on generic firm X and buy a bunch.  Then some bozo on CNBC says he likes it too.  What are the chances that you go back and double-check your thesis and evidence again after this?  It's 0%.  Your goal is to increase this percentage.  The more people love your positions, the more doubtful you have to be.  If you think you are right just because somebody else agrees with you, that's the narcissism talking.  Trust no one.  Do your own work, check it, and then check it again, and for heaven's sake, talk to people you vehemently disagree with.