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Flight to Liquidity


Those ETFs look pretty good about now...

One pattern I have been studying in detail lately is the interaction between volume in exchange-traded funds (ETFs) and the volume in their respective component stocks. There could be several reasons for divergences between the two - in the case of the ETFs for the S&P 500 and Nasdaq 100 (SPY and QQQ respectively), I think extreme volume moves are a read on the uncertainty currently in the market. Since those two ETFs are so liquid and easy to trade (no uptick rule for shorting), they have become a favorite for individuals and institutions alike. If you are not quite sure on the market, would you buy shares in a company so if you have to get out quickly you may get serious slippage, or would you just try some shares of SPY or QQQ instead, where getting out is a snap? Many choose the latter. Those ETFs are also extremely popular with institutions, allowing them to initiate and remove hedges quickly. For example, block trading in SPY, which counts trades for 10,000 shares or more at a time, accounts for between 30% - 50% of all volume in that ETF.

By comparing the volume in these ETFs to the volume in the underlying stocks, we can see how much the ETFs are being favored over and above the underlying securities. In the chart below, I have shown how much volume in SPY is "excess" compared to the volume in the underlying components of the index. At times of great uncertainty, such as March '01, September '01 and July '02, volume in SPY exploded compared to that of the underlying stocks. It was also very high at the lows in March '03 and March '04. On the other hand, volume in SPY dried up - showing relative complacency and lack of a need for hedges - at most of the market peaks seen over the past few years.

Currently, we have seen a pretty hefty flow of volume into SPY compared to the underlying stocks. While the current level of "excess" volume is high compared to other readings over the past few years, it is not extraordinarily high like we saw a couple of months ago. When we compare QQQ volume to that of the stocks of the NDX, however, we are currently seeing the largest "excess" ETF volume over any other time in the past two years. These volume patterns would support a rally at any time, but I don't believe are good reasons in and of themselves to count on one immediately.

This is by no means a perfect indicator. Like everything else, it has had some failures along the way. Also, its history is relatively limited, so it's difficult to know if this is a recent phenomenon that will peter out, or if it is here to stay. Personally, I think it captures a market truism - that investors flee to liquid instruments in times of great uncertainty - so will continue to be consistently effective.
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