Note: A version of this article appeared on the Trading Markets site 12/9/05.
On the surface of it, NASDAQ trading--and trading the tech stocks specifically--is the best it's been in years. We're seeing new bull market highs in the major NASDAQ averages and such stalwarts as AAPL and GOOG are pacing the market. Yet not all is well in NAZ trading land. Volatility--that index quality most prized by short-term traders--has been leaving that market at an alarming pace. We all know that volatility is down in the S&P 500 and that the VIX has been trading at or near multi-year lows. Less acknowledged is that the NASDAQ 100 Index has been losing volatility relative to even the S&P 500.
I owe this interesting observation to Paulo de León, an observant reader of my new market analysis blog. Perhaps it takes a market observer from Guatemala to see what has been under the noses of American traders for a while: the NAZ is not the trading index it used to be. Perhaps this is a function of traders simply voting with their feet. A look at my database finds that 100 day average volume in the SPY exchange traded fund has increased by about 41% since January, 2003. The corresponding volume in the QQQQ ETF is up only about 2%. Overall NYSE volume has risen about 18% since January, 2003; NASDAQ volume is up only 5%.
But, as Mr. de León notes, it's in the area of volatility that we can truly see the recent shortcomings of the NAZ. Below, I charted a 100-day moving average of the volatility of the NASDAQ 100 cash index minus the volatility of the S&P 500 cash index. I computed volatility by summing the individual trading ranges for each day. What we can see clearly is that the difference between NDX and SPX volatility has been steadily declining. It is at its lowest levels since the mid 1990s--and the lowest level since January, 1998.
In his missive, Mr. de León asks why NDX could lose so much of its volatility given its composition. To answer that question, we turn to research from my Cornell University, my old stomping grounds in Ithaca, NY. Charles M.C. Lee and Bhaskaran Swaminathan published an article in the Journal of Finance (October, 2000) that found an interesting pattern in stock trading. Over relatively short time frames (measured in months), high volume rising stocks tend to outperform the general market. Over a longer time frame of up to five years, however, those high volume rising stocks tend to underperform the broad market. The authors observe that, with time, high volume winners tend to become high volume losers and then settle into patterns of being low volume losers. Only later might they return to their winning ways, initially on low volume.
Lee and Swaminathan refer to this process as the Momentum Life Cycle (MLC). They hypothesize that there is a normal developmental process among stocks in which low volume winners become noticed by investors and become high volume winners. At this high volume, winning stage, the stocks are ideal trading vehicles but less attractive as long-term investments. This is because the high volume winners are unusually vulnerable to negative earnings surprises, which rapidly transform them into high volume losers. Such an event disheartens investors and leads to a decline in volume, which in turn discourages traders.
The MLC explains much of the boom and bust we've seen in past markets, such as gold and Japanese equities, and it could well explain the decline of the NDX as a trading vehicle. This is not to say the NDX--or its components--are not tradable; it simply means that the best days of its life cycle may be behind it.
The implications for the current market are profound. If the MLC hypothesis holds, high volume winning stocks--GOOG comes most immediately to mind--are today's trading favorites, but may not be the best investments for the next several years. Yesterday's favorites--those tech stalwarts--are also not likely to be tomorrow's shining investments or exciting daytrading vehicles. Those, Lee and Swaminathan suggest, are probably found among today's less heralded low volume winners. My next article will take a look at those.
Brett N. Steenbarger, Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and author of The Psychology of Trading (Wiley, 2003). As Director of Trader Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training program for traders. An active trader of the stock indexes, Brett utilizes statistically-based pattern recognition for intraday trading. Brett does not offer commercial services to traders, but maintains an archive of articles and a trading blog at www.brettsteenbarger.com and a blog of market analytics at www.traderfeed.blogspot.com. He is currently writing a book on the topics of trader development and the enhancement of trader performance.