How Fed Policy Has Kept Investors Out of Market
Sure, Federal Reserve stimulus may be feeding a major stock surge, but it also could be having the unintended effect of chasing traffic from the market.
One of the hallmarks of the past four years has been the lack of volume, or the amount of shares traded on exchanges during a given day.
Even as the indexes continue a mostly inexorable trudge higher, stock traders as well as the retail mom-and-pop investors have stayed away, taking February volume down 14 percent over the past year and 66 percent from the same period in 2011.
While some analysts have blamed geopolitical turmoil, political gridlock in Washington and a general mistrust of the market, the real reason could be much simpler.
It could be that Fed policy is perhaps working a bit too well, quelling market volatility so much that there's simply no reason for the traders who keep traffic flowing to bother with the market.
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"There's a very old trader saying: When there isn't anything to do, don't do anything," said Nicholas Colas, chief market strategist at ConvergEx. "Lower volatility means there are fewer things to do."
To gauge volatility most traders turn, appropriately, to the CBOE Volatility Index (VIX).
The VIX often is referred to as the "fear gauge" though it's been more like an apathy gauge in 2013. While the index has seen a handful of record-setting trading days this year, it remains at levels that suggest little urgency among traders.
Low market volatility is among the principal goals of the Fed's bond-buying program, known as quantitative easing, that has coincided with a 130 percent surge in the Standard & Poor's 500 and depressed interest rates to negative real levels.
"People make the mistake that Federal Reserve policy is about making equities go up. It's really about making volatility go down," Colas said. "Those two things just happen to correlate inversely."
The problem with a low volatility market, though, is that it makes traders miserable, and unhappy traders mean less trading.
(Read More: Stocks Rally Even As Volume Wilts)
Low volatility makes it harder to get the sometimes minuscule price fluctuations that traders use for arbitraging, and because arbitraging is more difficult there is less incentive to trade. The phenomenon creates a vicious cycle that depresses market volume even as it pumps up market prices as sellers disappear and buyers dominate.
A look at flows into both mutual and exchange-traded funds tells an interesting story about market behavior in the age of endless Fed stimulus, as money has flowed into the market but fewer trades are being executed.
Stock-based mutual funds hemorrhaged $153 billion in 2012. But they have turned the tide a bit in 2013, taking in $56 billion, a number that while a marked change barely makes up for the outflows just in November and December, according to the Investment Company Institute.
(Read More: Fed Keeps Easing, Not Worried About Stock Bubble)
Exchange-traded funds have nearly doubled that total, siphoning in $107 billion after taking in more than $300 billion in 2012, according to ETF research firm xtf.com. The direction in money flows is significant in that most retail money goes to mutual funds because they have almost exclusive control over 401(k) funds.
But even with the huge inflows to ETFs, which differ from mutual funds in that they trade like stocks, trading volume in the $1.46 trillion industry has fallen 22.5 percent this year alone despite the increase in total assets.
The lack of participation has posed a conundrum for investors but is unlikely to change as long as the Fed's aggressive easing policies hold down volatility.
"Who knows, maybe we have a couple more innings in this rally. Maybe volume doesn't quite matter as much," said Ryan Detrick, senior technical strategist at Schaeffer's Investment Research. "You look at the market making new highs, and mom and pop are still out."