Why Low Volume a Concern for Investors

A sharp drop at the tail end of January was followed by a nice rally to start the first half of February. The market has recouped most of those losses sustained in January. Pundits praised a resilient market and claimed investors seeking long-term capital appreciation knew market depreciations were buying opportunities. However, most traders sifting through the data might tell you a different, more ominous tale.

Changes in wealth occur every second, but most investors can tolerate the micro-sized events. What most investors tend to ignore is the strength in those changes, and this conviction is measured in volume – the amount of shares traded in a given day. It is how one can “read between the lines” and assess the conditions of overall sentiment. Low volume indicates less conviction in the direction of the market, and that is what we are currently witnessing. Volume generates confidence that allows the market to maintain a positive cash flow creating rises in stock valuations.

Let’s use an example to understand the theory. Imagine I was the CEO of a public company called Vacuum Inc. and you owned some shares. On a typical day, the amount of shares traded is 10 million. However, over the past month, the volume has declined to only 4 million, yet the shares are up 5 per cent. What does this mean? Why should an individual care about liquidity?

Low volume suggests that there is less conviction in the direction, as we stated earlier. There could be a number of reasons why the strength of the rise is questionable. Perhaps, big money has maximized their allotted positions on Vacuum Inc., or they have funds tied up in other parts of the market, or demand is reduced due to business concerns. Whatever the reason, it can suggest a negative trend.

Let’s take this example to the extreme. Let’s say volume was 100 per day for the last month with the shares rising 5 per cent. This would indicate that a small group of traders, perhaps even just one person, was propping the value of the shares by buying and selling between themselves. Now, for investors ignoring the variable of volume, the rise in equity appears good. Vacuum Inc. has just increased your overall wealth, but the underlying issue of low volume should trigger red flags. The elevated price of the shares are not an accurate assessment of valuation. There are other variables one could examine, such as buy orders through market depth, to verify unrepresented strength, but under normal conditions, one would assume that liquidity is minimal, so if shareholders decided to sell and volume rose back to 10 million, we may eventually see large drops in price. The price you receive per share is the accurate value of the stock.

The reduction in stock volume represents a fundamental change in investor and trader behaviour. With economic conditions muted, this limits growth of participants in the stock market. Since the stock market is essentially a zero-sum game, debateable by many scholars and professionals, it requires continuous net positive cash flow into the market to create long-term wealth. Investors already in the market looking to sell in the future may find that drops in liquidity are not beneficial, especially since most trades created throughout the day are executed by institutions.

Another reason investors need to care about liquidity is that it stabilizes markets. A system that has a billion shares trying to buy and sell will create less volatility than a system that has just thousands. Spreads between the highest buyer and the second highest buyer can be huge. Imagine yourself selling a home to just a pair of shoppers. One offers $400K and one offers just $350K. Your options are limited. But imagine your home having bids from a dozen people, well suddenly, the price received to sell if the top bidder backs out might still be closer to your asking price.

Concerns on volume have been a discussion for the last few years. As US markets continue to reach all-time highs, some wonder where investors are. With a lack of investors participating in the stock market's rise, many question the validity. This chart, from July 2013, shows a significant down trend in trading over the last half-decade, courtesy "The Wall Street Journal."

And if we examine the archived data directly from the NYSE here, we see the same information being upheld in the chart above. Some may say that a rising market means fewer shares are traded at higher prices, however, what we do see is that this is not true. In fact, the dollar volume has also decreased.

It's hard to imagine the stock market's volume being reduced to mere thousands per company, or millions per exchange, but the underlying issues that could lead to such a scenario should be educated. The biggest culprit to wealth is not falling prices as some believe, but in fact liquidity. Without the ability to participate or sell in any kind of market, what motive is there to buy a company whose shares might take days to withdraw from?