Four Ways to Profit When Market Volume Takes a Plunge

Sure as the luck o' the Irish, the stock market's best fortunes over the past year have coincided with a low level of interest from investors.

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If anything has punctuated the market's violent rally off the March 2009 lows, it has been the conversely anemic trading volume during many of Wall Street's best days.

Primary volume for nine of the past 24 trading days has been below 1 billion shares, and much of the activity has been high-frequency trading as opposed to investors taking measured positions in long-term strategies.

So why can't anyone get excited about a market that has generated a 70 percent return over the past 12 months?

"In general we've lost over the last couple of years the aggressive buyer population in the market," says Michael Cohn, chief investment strategist at Global Arena Investment Management in New York. "So it's not unusual to climb a wall of worry on low volume."

The lack of interest, though, doesn't necessarily make for a bad investment environment—to the contrary, in fact. Four things to consider:

1. 'Never Short a Dull Market'

Yes, that old chestnut.

The reasoning behind the ever-popular market maxim is pretty simple: Skeptical investors tend to wait until a market peaks to truly buy in. By that time, it's too late, and sellers start taking over. When the market is dull and makes quiet moves up, as has been the case for most of 2010, the direction often continues higher.

"People are content to make 5 percent and not worry about losing money. As long as that mentality is there, the path of least resistance is to the upside for the market," says Ryan Detrick, analyst at Schaeffer's Investment Research in Cincinnati. "The public is very skeptical where they need to be. The market climbs a wall of worry and we still feel that worry is present and that makes us comfortable to be long."

Indeed, some of the market's worst days have been on its highest volume, again indicating more conviction from sellers than buyers.

2. Low Volume = High Market

Though the pattern doesn't hold universally, it's a good bet that big dips like the Feb. 4 268-point Dow drop will come on respectable trading levels (1.48 billion in primary volume) and moves higher will happen on weak days, such as the Feb. 16 pop of 170 Dow points on just 1.07 billion shares.

Testament to the market's low-volume strength has been the willingness of buyers to jump in after those high-volume big-drop days.

"The market has been trending higher as buyers have been reluctant to chase stocks," says Bennett Gaeger, managing director of tech trading at Stifel Nicolaus in Baltimore. "Where there are some negative liquidity events (such as bad economic news) people are taking advantage when we see stocks for sale and buying on the dips."

"Volume doesn't seem to be the indicator it was," Detrick adds. "We are comforted by this slow and steady rise with some scary pullbacks. We like those, also. To us that's a nice mixture."

Two More Big Things to Keep in Mind

3. Capitalize on Complacency

Most analysts agree on two points: The market is substantially overbought, but the low level of fear among investors means the rally remains largely unthreatened. The Chicago Board Options Exchange Volatility Index has tumbled to its 2010 low—in fact to a level it hasn't seen since its pre-financial-collapse levels of May 2008.

"The volume is so anemic in so many areas—it's flashing red for us all the way across the board—but they keep pushing (stocks) higher," says Kathy Boyle, president of Chapin Hill Advisors in New York. "This feels like a game of musical chairs."

Following the 2009 run-up in high-beta, low-performing stocks that took the worst of the beating in the 2007-08 collapse, many advisors are focusing on large-cap big-balance-sheet companies.

The lack of market conviction, though, has some believing the opposite strategy could prove fruitful.

"We still think the places you should invest are the areas considered riskier by most people," says Detrick, who recommends restaurants, retailers, consumer discretionary and real estate investment trusts, which have become a favorite whipping boy for a growing number of analysts who think REITs will get crushed by the commercial mortgage troubles likely for this year.

4. But Don't Get Crazy

Gaeger says most of his clients are putting aggressive stop-loss provisions in their trades to make sure they don't get caught if sellers come crashing into the market.

Unbridled optimism would be the market's biggest enemy now, and the most recent survey from the American Association of Individual Investors shows bulls outnumbering bears by 20 points—a gap that has been indicative of a looming mini-correction in the 5 to 7 percent neighborhood.

"The majority of people get in at the top and get in high. Volume conviction only shows itself when people are convinced the market is going up," Global Arena's Cohn says. "It's a lot harder to pick tops than bottoms."

Boyle says technicians seem convinced the Standard & Poor's 500 is inexorably headed to 1,200—a 3 percent gain from here—but investors should be careful not to get caught in a crosswind.

"Lack of volatility and light volume does mean that any trade you do you've really got to watch what you're doing," she says. "Most of my trading clients are putting trailing stops on. So you're forced to go long, even though you may not have conviction."