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Monday, October 4, 2010 - 14:26
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Thursday, August 15, 2013 - 11:09
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Monday, October 4, 2010 - 14:26

Wall Street's Hands are Tied -- and That's a Good Thing

Monday, October 04, 2010 2:26 PM

In recent weeks, stock market pundits have been wrestling with a curious phenomenon. Trading activity has fallen sharply, which these market-watchers presume to mean that investors have lost interest in stocks. Mom-and-pop investors have likely become more gun-shy this year. But the main culprit for lower trading volumes: Wall Street's own trading desks.

Recent regulations have forced major investment banks to shrink divisions that have used house money to bet on the stock market. Some firms like Bank of America (NYSE: BAC) are getting out of the business altogether. These "prop trading" desks had been a solid source of profits, and Wall Street is surely sorry to see them go.

The ostensible reason for these new regulations is that it makes the whole financial system less risky. If there firms aren't putting their own money at risk, they are less likely to fail. For the rest of us, the demise of prop trading is a clear positive. That's because Wall Street has just lost the incentive to save the best ideas for itself for a while.

Just ask Goldman Sachs (NYSE: GS). Even as Goldman was telling clients to buy slumping housing stocks and bonds in 2008, its own prop trading desk was betting against housing -- kind of like a used car dealer pawning a lemon off on you.

The decision to shrink or exit the prop trading business won't deal a sharp blow to the major banks. The prop trading divisions typically account for just 8% to 10% of revenue, and since their results can be very volatile, analysts don't tend to assign a high value to their profit streams. Nevertheless, the fact that consensus earnings forecasts for Citigroup (NYSE: C), JP Morgan (NYSE: JPM) and Bank of America have held up even as its increasingly clear that banking and trading business has slowed in recent months should give you pause. Each of these firms is expected to report quarterly results during the next two weeks, and their shares may be vulnerable to a reduction in forecasts.

The steady wind down of trading at many prop trading desks is already being felt as trading volume is clearly slumping. IBM (NYSE: IBM), for example, traded less than six million shares daily, on average, in August and September. That represents the lowest volume of the year, which is not necessarily a bad thing for large company stocks. But lower volume means that bid and ask spreads on micro-caps and small cap stocks may be a bit wider than usual (as volume in a stock rises, market makers compete more aggressively to fill stock orders and the bid/ask spread shrinks). So it makes sense to place a limit order rather than market orders on these smaller stocks.

Shrinking volume
As noted earlier, declining trading volume is viewed as a sign that individual investors have lost interest in stocks. But the exchange-traded fund (ETF) phenomenon brings that into question. Many exchange-traded funds have seen a commensurate rise in trading volume that roughly offsets the trading volume of individual stocks. For example, the SPDR S&P 500 ETF (NYSE: SPY) used to trade less than 75 million shares per day back in 2005. By 2007, that figure routinely exceeded 100 million and it now averages more than 200 million. [6 Rules ETF Investors Must Know]

The shift away from stock picking and toward ETFs tells you that stocks in a specific sector are more likely to move in lock-step, at least in the short-term, as these ETFS buy and sell all of the components in tandem. For investors with a medium to long-term time horizon, stock-picking is still a winning strategy as fundamental factors like sales and profit growth will always be the long-term determinant of stocks.

Action to Take --> The demise of the individual investor is a current theme playing out among market pundits. Don't you believe it. As the economy sputters back to life in 2011 and 2012, stocks are likely to find newfound favor as they remain cheap by historical standards. The fact that trading volume is light right now simply gives you more time to sharpen your best research ideas. And as noted earlier, Wall Street may be feeling some pressure from changing business trends, but that's not necessarily a bad thing for you.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.