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Beware risks of illiquid, low-volume market

Published Wed, Sep 3, 2014 · 10:00 PM
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THERE is mounting frustration among yield-hungry investors at the state which equity markets find themselves in, with liquidity and volatility having fallen sharply over the past six months. In Singapore for example, stockmarket turnover was about 30 per cent lower for the first seven months of 2014 compared to the same period in 2013. Meanwhile, over on Wall Street when the S&P 500 closed above 2,000 for the first time last Friday, trading volume was the lowest in 2014 while the VIX index of volatility at 12 is just off its 52-week low of 10.

The longer activity remains as subdued as it is now, the greater the frustration. Logically, this increases the chance that players will either be tempted, or be forced, to take on greater risk to enhance returns. On this count, it would be wise to tread carefully. To some investors, low volume and low volatility indicate a low-risk environment since it implies that selling pressure has been well-absorbed, or that it has not been widespread. This would be a mistake - low volume brings with it a different set of risks; for example, it means investors will find it hard to exit swiftly when the need arises. It also means price movements can be exaggerated, which could be particularly worrisome when selling emerges.

The source of the liquidity decline is the US Federal Reserve's "tapering'' of its quantitative easing (QE) monetary stimulus programme, with the final taper expected next month. Interpreting the drop-off in volatility, however, is trickier. A benign credit cycle has contributed - when monetary policy is loose and credit easily available, volatility tends to be low - though a likely additional explanation is that markets are unsure of whether QE will lead to sustained growth and what this means for interest rates.

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