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The End-of-Year Downshift Is Beginning

With the last major central bank meeting of the year (the Federal Reserve’s) due on Wednesday, and few important pieces of data ahead aside from Friday’s CPI, markets seem to be starting the inevitable downshift into the end-of-year holidays. Admittedly, it is somewhat hard to tell. It looks like aggregate equity volume in 2012 will be down a stunning 28% or so from 2011 (see chart below, source Bloomberg). This continues a recent trend, but accelerates it as well.


I’ve discussed in these articles in the past the possible causes of this seemingly-secular decline. I believe that there are at least two causes. One is not particularly worrisome; there was probably already a trend in place for volume to move off of organized exchanges to “dark pools” and the like. But the recent drop in volumes seems more likely to be caused by recent events, and judging from anecdotal evidence I’ve seen – namely, that market-makers are reducing the scale of their operations across almost all products because of the regulatory difficulties of maintaining those operations – a big part of the recent decline is likely to be attributable to the gradual implementation of Dodd-Frank and the Volcker Rule. This is something less than shocking. What hasn’t yet happened, but I suspect may, is that asset prices themselves decline if liquidity is meaningfully impacted by declining volumes. For any given asset, the fair price is a direct function of liquidity (as well as many other things, of course), which is why there is such a thing as a ‘liquidity discount’ enshrined even in tax law. The decline in liquidity itself is probably non-linear (since market-makers will be less aggressive as they perceive other market-makers being less aggressive), and therefore the decline in asset values is likely non-linear as well.

Not to mention being totally unpredictable as to timing, I might add. But there is something to the old rule of technical analysis rule that markets can go down on big volume, but they can’t typically go up for an extended period on low volume.

Global political events haven’t yet left town for the holidays. Italian Prime Minister Mario Monti announced on Saturday that he plans to resign after former Prime Minister Berlusconi withdrew his support. 10-year Italian yields jumped 30bps to 4.81%, but remain considerably below the levels associated with any serious concern about Italy (see chart, source Bloomberg).


Across the Ionian Sea, Greece extended the original deadline for its debt buyback by two days,  signaling that it hasn’t reached its target. According to reports, the government has received tenders for €26bln (in face amount) versus its target of €30bln. However, the important number is the difference between the face amount of the debt offered compared to the price paid by the government. That number needs to get to €20bln, and there is no way to know if the government is close. If they have overpaid relative to the 33 cents on the dollar they were expecting to pay, and have spent, say, €10bln to get those €26bln in tenders, then they’re not really all that close. If they have spent €7bln, then they’re very close and I would guess close enough. I’m not sure we know.

In the U.S., no apparent progress has been made on the fiscal cliff.

But here’s a little story that caught my eye. “NYC Base Subway Fare May Rise to $2.50, Board Members Say.” I only point it out because the 11% hike in base fares seems out-of-place with a weak economy…if, that is, you think that economic growth causes inflation. Personally, I don’t believe in that old, discredited notion, but some people do.

Looking forward over the balance of the month, I don’t expect that we will see a Santa Claus rally in equities. Although we got such a rally in 2010 (+6.5% in the S&P 500), and smaller ones in 2009 (+2.8%) and 2011 (+0.9%), there seems to me to be too much uncertainty for investors to make significant bets into the end of the year. The outcome in December is likely to be decided by a coin flip – if the fiscal cliff is resolved, then equity markets will rally (and that rally probably should be sold, since the underlying fundamentals are still very poor); if the fiscal cliff is not resolved, stocks will slide into the end of the year (and that selloff is probably worth buying, if it’s deep enough, since there’s a reasonable chance that the issues are resolved after both sides realize the other side isn’t going to blink). I’m not sure that’s a market I want to have a strong commitment to right now, in either direction.

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