Volume Levels Pose Serious Concerns: SPY, DIA, IWM, QQQ

This market is on the verge of falling hard, but most people do not see it.  In fact, the market is so close to all-time highs that most people are fixated on it making new highs, rather than paying attention to valuation or macroeconomic conditions, both of which present serious risks.  I’ll talk more about these, but first, there’s something else...

Markets can move up in the face of risks, in fact they often do, but the way in which they move up is also often an important tell.  I see one of those right now.

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This has only been happening for 2-3 days so far, but I have seen this happen for weeks on end, and it is good to catch it at the beginning, especially if it persists, because traders can use it to their advantage, and for investors it’s a red flag; both are opportunities, one to profit and the other to control risk.

This market is being driven higher by smaller investors, and institutional investors are selling into the rallies.  I am using volume levels to help me define this, because we can never be 100% sure until well after the fact, but this observation has held true in the past.

It has been happening as follows:

  1. The Market increases early and drifts higher on very light volume.
  2. Declines are short lived, and buyers seem to come back on every dip.
  3. Good news is GREAT, bad news is ignored, and neutral news is considered good.
  4. In the last hour of the day, regardless of news, selling pressure hits and volume levels spike.

This action can be seen clearly in the market ETFs: SPDR S&P 500 ETF Trust (NYSEARCA:SPY), SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), iShares Russell 2000 Index (ETF) (NYSEARCA:IWM), and PowerShares QQQ Trust, Series 1 (ETF) (NASDAQ:QQQ)

After anemic volume levels for the beer part of the day, over the past two days volume levels increased by about 50% in the S&P 500 in the last hour of the day.  In fact, on Tuesday, volume levels spiked by 37% in the last 30 minutes alone, and on the heels of these volume spikes the markets have fallen relatively hard late in the day.  That is a red flag.

Traditional theory tells us that smaller investors take action at the open, and institutional investors take action at the close.  Clearly this is not set in stone, but it is true that we often attribute late day action to institutional activity, whether that be buying or selling.  Many managers watch for this activity.

What I am seeing is consistent with that traditional theory.

Smaller investors are bidding the market up early, and institutional investors are selling into the rally late, but there’s more.  The low volume increases also tell us that institutional investors are not, for the most part, buying along with smaller investors early in the day.  Instead, they seem to be simply not selling, and by not selling they are allowing the smaller investor to bid the market up; if there are no sellers, a small amount of buying could push the market higher, and that’s what’s happening.

I have argued that institutional investors are carrying more margin debt as a percentage of cash on hand than ever before, putting the Cash-Margin ratio at an all-time low, and that hampers institutional ability to buy, but if they don’t sell the smaller guy can bid this up.  That’s what is happening here.

However, that Cash-Margin Debt ratio also supports the notion that institutional investors are selling into the rally too, if for no other reason than to simply reduce margin debt exposure.

Although I cannot be sure, I assume that most institutional investors recognize the valuation risks and the macroeconomic risks that exist today, and they are simply letting the smaller investor buy as they sell into the rally on what has been a consistent basis so far.

This can happen for days on end, but my experience has told me that it is followed by aggressive declines too, and that means buy and hold investors should be taking action to protect themselves.  Seeing this happen near all-time highs in the face of the macroeconomic and valuation risks makes it even more sensible to control risk.

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