[ Editor's Note : U.S. stocks advanced for the fifth day in a row yesterday (Wednesday), with the Standard & Poor's 500 closing above the 1,200 level for the first time in more than 18 months. Traders cited growing confidence in the U.S. rebound as a key catalyst. But could stocks be vulnerable? Contributing Editor Shah Gilani spotlights a risk that traders are overlooking.]

Conventional investing wisdom tells us that when stocks rally on low stock market volume, traders perceive that lack of widespread participation as an indicator of the market's future vulnerability.

And as torrid as this rally in U.S. stock prices has been, the lack of trading volume has been a consistent cause for concern.

Unfortunately for market bulls, even this well-chronicled concern doesn't tell the whole story. That's because U.S. stock market volume is even worse – actually, much worse – than anyone realizes. And this ultra-low stock market volume should be sending up some serious red flags for investors.

Pump Up the Volume …

Other than actual stock prices, trading volume is one of the most closely watched measures of stock-market health. Volume is both a number – a measure of market liquidity based on the number of shares that change hands each day – and an indicator – demonstrating just how much confidence traders have (or don't have) in a particular market trend.

Larger-than-normal volume is viewed as a sign that traders are confident in the market trend at hand. Movement on low volume is seen as an indicator of a trend that's unlikely to continue.

That's why – despite the near-record run-up that U.S. stocks have enjoyed from their March 9, 2009 post-financial-crisis stock market lows – the light volume that's accompanied this move has been so irksome to investors.

Unfortunately, the perception is much better than the reality. And thanks to three key factors – high-frequency trading (HFT), the proliferation of exchange-traded funds (ETFs) and active-arbitrage trading – current stock-market volume is far worse than investors even imagine.

High-frequency trading (HFT) conducted by proprietary trading desks at big banks and private hedge funds accounted for 70% of equity trading volume in 2009, according to a paper released last month by the Federal Reserve Bank of Chicago.

The massive proliferation of exchange-traded funds (ETFs) that have become so popular with retail investors is also a major cause of the misleading stock-market volume statistics. And not because they are traded by investors, but because they are traded by a handful of privileged "INSIDERS."

In addition to HFT share volume, active arbitrage trading by "authorized participants" increases daily volume when these insiders buy and sell the underlying securities that make up ETF portfolios against their simultaneous trading of the actual ETF shares.

How these active traders increase volume and what that means for markets is important.

They Don't Call it 'High Frequency Investing'

High-frequency trading is not investing. HFT incorporates mathematically driven algorithms that prompt powerful computer systems to look for statistical patterns and pricing anomalies by scanning the various stock exchanges and alternative trading networks.

When an opportunity arises to profit from what practitioners of these incredibly profitable strategies call "statistical arbitrage," traders employ massive leverage and execute their trades by using super-fast computers. Typically, these trades are executed in nano-seconds (billionths of a second) and the opportunities can be over just that quickly, or may last for minutes or hours. Less frequently, some of these types of trades are held for a few days, or longer.

TABB Group, a financial-markets research firm, says that high-frequency trading accounts for 73% of all equity trading, up from 30% four years ago.

Still, trade volume on the New York Stock Exchange is 25% lower this year than it was at this same point last year. The 200-day moving average is now at 1.2 billion shares a day, down from 1.6 billion, according to The Associated Press.

As anemic as that sounds, the reality is actually even more dour: Of the 1.2 billion shares traded per day, 876,000,000 shares change hands because of short-term trades executed by "stat arbs" (statistical arbitrageurs)- and not because of investors.

Members of the stat-arb crowd argue that they provide increased liquidity to the markets as willing buyers and sellers, comparing themselves and the role they play to that of market-makers and specialists. And while there are some similarities, the bottom line is that stat arbs are not market-makers and do not have the same fiduciary duty as market-makers and specialists do, which is to "keep fair and orderly markets."

The volume that HFT strategies generate is problematic on three fronts:

It adds exponentially to daily volume, which masks what true liquidity might be in another panic sell-off.

The sheer volume of the institutional HFT activity creates a potential nightmare scenario, should human error or a computer breakdown unleash a torrent of backwards trades.

Finally, in addition to human frailty and a potential "ghost-in-the-machine scenario," a multiplier gets added to the blind-alley concerns, since many of these highly leveraged firms and desks are on the same side of many of the same trades.

There's a lot more to address regarding HFT – and what the Chicago Fed and the Securities and Exchange Commission (SEC) are concerned about – but the scope of this article concerns HFT and its impact on volume.

The other major contributor to daily volume is a cousin of the high frequency school of trading strategies. Only, while you may have been aware of HFT, you probably aren't aware of who these other insiders are and what they do on a daily basis.

I'm talking about exchange-traded funds.

The Underside of ETFs

Exchange-traded funds have exploded in both number and use. Their total issuance is fast approaching $1 trillion. They come in all shapes and sizes and offer daily-stock-market trading and liquidity. The underlying portfolios, indexes, benchmarks, styles and asset classes offer exposure to corners of the global financial markets that traditional retail investors never before had access to.

In short, ETFs are both an investing phenomenon and a financial juggernaut.

What most investors don't know is that exchange-traded funds are also designed to generate conventional-trading and risk-free-arbitrage profits for the insiders who act as custodians of the ETF units they create.

The sponsor of an ETF usually engages a bank, brokerage house, investment firm or market-maker to become an "authorized participant" whose job is to "create" the units that will become the "shares" of the ETF. Of course, Wall Street being Wall Street, a sponsor can hire itself – or an affiliated entity – to be its authorized participant.

In the case of equity ETFs, the authorized participant goes into the market and buys shares of all the stocks that will serve as the ETF's underlying portfolio. In some cases, futures, derivatives, customized contracts, or even some other types of financial instruments, are incorporated into that mix, either in addition to – or even in lieu of – the actual underlying stocks.

For purposes of simplicity, we'll stick with the pure-equity model to make our example as simple and as clear as possible.

The authorized participant delivers the stocks it purchased to the sponsor, who deposits them with a trustee. In return, in what's known as an "in-kind" transaction, the sponsor turns around and provides the authorized participant with "creation units." Creation units are blocks of between 10,000 and 600,000 shares of the newly minted ETF.

When a retail investor purchases shares of this newly minted ETF, the authorized participant delivers them to the investor's broker. Once shares are delivered to the first buyer, anytime that an ETF shareholder wants to sell his shares, the process is the same as if he were merely selling a conventional stock – through his broker and through the corresponding exchange where the securities are traded.

For the authorized participant, here's the really great point: They are free to trade the actual ETF shares that they helped create – as well as any and all of the underlying stocks that make up that ETF.

In fact, these institutional players trade them both simultaneously and extensively. It's a very pure form of arbitrage. Arbitrage is essentially the simultaneous trading of two similar (or identical) financial instruments. The objective: To make a risk-free profit from a difference in prices.

The simplest example of an arbitrage would be if you could buy XYZ shares on the Big Board in New York for $40 each, while simultaneously selling the very same number of XYZ shares on another exchange (say, Philadelphia or London) for $40.25 each. You would pocket a risk-free profit of 25 cents on each share. That may not sound like much, but imagine doing that several times a day, during each trading day of the year, and to the tune of a million shares for each transaction!

Authorized participants execute their own form of arbitrage: They buy and sell ETF shares on the exchanges and simultaneously buy and sell all the underlying shares of the stocks that make up the ETF tracking portfolios. They make risk-free profits by conducting this arbitrage when the prices of the ETF shares do not precisely correspond with the value of the underlying portfolio of stocks.

From a pricing standpoint, this is a very good thing: It serves to keep the net-asset value (NAV) of an ETF in line with the value of the underlying portfolio of stocks that the ETF represents.

But from a volume standpoint, this specialized trading creates a false marketplace perception: It artificially elevates the share-trading volume in both the ETFs and in all their underlying stocks.

Protecting Yourself From the Weak-Volume Fallout

To this point, I have been unable to find any specific, publically available statistics on how much share-trading volume this arbitrage creates. Rest assured, however, that the additional amount is huge and that – as is the case with HFT – it is not investment-related trading volume. It is very-short-term trading volume. And it adds considerably to the daily market-volume tally.

The net effect of arbitrage trading (high-frequency traders also execute arbitrage trades in ETFs, in competition with authorized participants) is that investment volume is considerably lower than investors perceive it to be.

None of this matters much as long as prices are rising, which we've said could potentially continue for some time to come. But if U.S. stocks do correct, there's a very good chance that the net effect may be less liquidity on the way down than there is on the more orderly way up.

And that could sharply steepen any decline.

Whether or not the conventional wisdom – that markets that rally on thin volume are dangerous – will be proven correct by any meaningful downturn remains to be seen. But I'm not one to flout such wisdom out of hand – especially if there's a simple and low-cost way of protecting myself against such a possibility. I recommend that investors take prudent measures by maintaining stop-loss orders that can protect them if this low-volume environment happens to result in a steep sell-off.

[ Editor's Note : This essay demonstrates yet again of how investors can use the powerful financial trends known as "capital waves" to help them shape their investing strategies. It's a premise that Money Morning Contributing Editor R. Shah Gilani has shared with readers time and again. And it's an investing approach that's allowed Gilani to correctly anticipate some of the biggest events that occurred during the ongoing global financial crisis.

A retired hedge-fund manager and gifted analyst, Gilani regularly takes readers behind Wall Street's "velvet rope" – and into the world he knows so well – exposing the pitfalls that can inoculate investors against ruinous losses even as he highlights profit opportunities that most other experts never even recognize.

It's no surprise that Gilani's essays have been read by millions.

With his new advisory service – The Capital Wave Forecast – Gilani shows investors the monster "capital waves" now forming, will demonstrate how to profit from every one, and will make sure to highlight the market pitfalls that all too often sweep investors away.

Take a moment to check out Gilani's capital-wave-investing strategy – and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. To read one of his most-popular essays, please click here.]



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