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ETF liquidity premium is a concept I learned from Jason Goepfert of SentimenTrader. Simply put, it quantifies whether traders prefer ETFs or the underlying stocks. The disadvantage of trading ETFs is that they can not possibly give the umph (my technical term for beta) of an individual stock. But ETFs offer an advantage that stocks can’t: liquidity. That is, getting in and out of a position - even in a freefalling market, is a breeze with an ETF.
It is understandable then, that when traders are spooked, they value this liquid characteristic of ETFs more than the volatile characteristic of individual stocks. The liquidity premium indicator is calculated by comparing the volume of the ETFs (SPY & cubes) to the sum of the volume of their respective constituents.
Taking into account the recent trading activity in the QQQQ and SPY, you won’t be surprised to learn that the liquidity premium has been hitting extremes:
The ETF liquidity premium indicator is now signalling that we have reached a critical point. The last time it was at these levels was in the spring of 2004. But, in the summer of 2002 it reached even more extreme levels. So the question you may be asking is, what does this all mean?
Well, if you think that we are still in a primary uptrend and just pausing here, then it would mean that it is time to load up for a resumption of that trend. But if you believe that we are at the cusp of a change in market conditions and in fact starting a major correction or cyclical bear market, then you would expect this indicator to reach even more extreme levels in the coming weeks and months.
Personally, I’m still in the intermediate bottom camp. But it’s getting mighty lonely in here.
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