Market can be dull, but don’t sell it short
Many traders in coming weeks will be even more on edge than usual, worried that light trading volume will sabotage the stock market’s recent rally back to record highs. But history suggests there is no reason to worry.
That doesn’t mean there aren’t plenty of other sources of concern — from a possible (though unlikely) interest rate hike by the Federal Reserve at its late-July meeting, further fallout from the United Kingdom’s vote to exit the European Union and continued uncertainty about the outcome of the U.S. presidential election — to name a few. But if the market does end up struggling between now and Labor Day, it won’t be because of light trading volume.
Its true stock exchange volume in July and August is typically below average, as many who otherwise would be trading are instead taking summer vacations and choosing not to be glued to their smartphones while on the beach. One telling data point is how each month’s NYSE trading volume compares to the average level of the trailing 12 months.
In all months besides July and August, average daily trading volume is 4% higher than the previ- ous year’s average — reflecting the steady growth in stock exchange volume the past 50 years. That growth grinds to a halt during July and August, however, when trading volume is lower than the previous year’s average. In August, in fact, it is 5% below.
But the summer’s light trading volume doesn’t have to be a drag on the stock market, says Blake LeBaron, a finance professor at Brandeis University, one of whose research interests is the relationship between volume and price. He says that this relationship is far more complex than most traders assume when they naively repeat the common Wall Street aphorism that “price follows volume.”
For starters, he points out, sometimes lower prices are actually correlated with higher trading volume rather than lower. We saw this as the stock market reacted to the United Kingdom’s surprise decision to leave the European Union, for example. The market immediately plunged on trading volume that was nearly triple the previous average. And as the market has recovered since then, trading volume has receded to that average level.
If we were to extrapolate from this and other similar examples, we should be hoping for light trading in coming weeks.
There’s a more fundamental reason we shouldn’t worry about the pace of trading activity, LeBaron says. Even when light volume is correlated with poor market performance, he says, statisticians haven’t been able to determine which is the cause and which is the effect — in other words, whether price follows volume, or vice versa. That means traders who base trades on the level of volume could end up reacting too late to turn a profit.
The bottom line: Stock exchange volume does not provide us with a strong enough signal to deviate from the general advice to focus on buying and holding good quality stocks for the long term.
In this case, yet another Wall Street aphorism turns out to be good advice: Don’t sell a dull market short.