Trader’s Narrative

For a while now, we’ve been concerned that volume hasn’t been powering the market higher. In fact, if you think of volume as fuel for any sustainable market rally, then we’ve been running on fumes for a few months. Since I wrote that in early June the market wobbled a bit and traced a shallow correction but before long it was on to new highs for the year. This has been a teflon coated rally.

But there is no mistaking that what we are seeing is a true outlier in terms of historical market performance. Here is a chart from Hussman’s most recent commentary which shows the six-month percent change in the S&P 500 from the bottom of each bear market (going back to the early 1940’s) compared to the percent change in volume over that same period:

Source: Hussman Commentary

As you can see, this rally is the largest one powered by the least volume. If we imagine a “best fit” line for the data, it would be going from the lower left to the upper right, implying that usually, the more volume, the bigger the recovery from a bear market low.

The state of volume (or lack thereof) is even more alarming when you consider that for the past year a baker’s dozen of stocks have grown to account for eyepopping proportions of total volume on the exchanges. Just to give you an example, on August 6th 2009 Citigroup (C) and Bank of America (BAC) accounted for 25% of total NYSE volume. Dr. Brett have brought attention to this last month: The Recent Concentration of Volume.

There are many theories about what exactly is behind this crazy volume: daytraders, HFT, short covering, secret government recapitalization, etc. Whichever reason is the real one, a market structure where total volume is distorted by such gigantic proportions from a handful of issues is, simply put, deceptive.

Yesterday’s Fast Money had an interview with Paul Desmond, president of Lowry Research:

He mentions the 90% downside volume we saw accompany Monday’s decline as well as the anemic volume behind the higher prices since April 2009 as reasons he thinks that this is not a real bull market.

Desmond thinks that we are heading lower and ultimately below the March 2009 because if that level didn’t attract enough strong hand buyers, then the market will have to go even lower (and get cheaper) to do so.

The discussion of 90% down days is interesting although the clip is too short to do justice to it. Although the seminal work of Paul Desmond on 90-90 days does rely on them, 90% down days by themselves are not necessarily all that bad news for bulls. Historically, the market doesn’t take a dive after 90% downside volume days (both in the short term and in the long term).

Bill Strazzullo of Bell Curve Trading is the other person being interviewed is a bit more ambivalent. He’s watching the 900 current level and thinking that the market will have a tough time climbing higher. I’m not familiar with him or his track record so if you are, let me know.

The spring rally that started on March 9th 2009 took the Standard & Poor’s 500 Index 37% higher by May 8th (almost two months exactly). Since then we’ve been bobbing and weaving, first lower, then higher but really not going anywhere:

It could just be that we have no come into areas of resistance which last pushed back prices in early January. Or there could be more a more insidious reason for the recent weakness in the equity market.

In a recent Wall Street Journal article, Paul Desmond, the award winning head of Lowry Research, argues that what we are seeing is not the start of a real bull market:

“A new bull market is one when investors are prepared to commit larger and larger amounts of new money to equities… What we have seen here is a very consistent drop in total volume going back to early April. Investors are risking smaller and smaller amounts of capital and that is a bad sign.”

Mr. Desmond says his data, going back to the 1930s, don’t show any new bull market with such a weak volume trend, which leads him to believe that this rally won’t become a lasting bull market.

Among the many metrics used by Lowry Research are two proprietary ones called ‘buying power’ and ’selling pressure’. Accordingly a bull market is distinguished by a rising buying power measure and falling selling pressure. While stock prices have certainly risen, there isn’t a demonstrable strength in Lowry’s buying measure. In fact, demand has been fading.

For further details about Lowry Research and how they analyze the stock market, check out: Lowry Research On Current Market Conditions.

A very old indicator that measures the magnitude of speculation on Wall St. is the volume ratio between the NYSE and the OTC market. This ratio hearkens from the early days when Nasdaq was the over the counter market where smaller and riskier securities traded.

This was before the time of Microsoft (MSFT) and Intel (INTC) - bellwethers of both the stock market and the US economy. Today it would be more apt to substitute the Pink Sheets OTC BB market instead.

Even so, for some reason the volume ratio still holds and has flagged important market tops. Including the start of the bear market in October 2007.

There is no absolute level however in this ratio that can give us oversold and overbought readings. As with all analysis of volume, we have to contend with not only a seasonal pattern, but also a continuous increase of trading over time. Since we are looking at a ratio, most of the upward creep in volume should be canceled out.

Right now, the volume ratio is extremely high and points to a lot of froth in the market. We’ve seen other signs of this in the sentiment data as well.

To play devil’s advocate, the ratio could be higher because of the Nasdaq’s leadership (it has rallied much more than the NYSE since March 2009).

If it is true that a lasting rally needs volume, then we are pretty much running on fumes here. While the market’s spring rally has been impressive, the volume behind it has been anemic. For example, take a look at last year’s spring rally and you’ll see the same pattern: higher prices accompanied with lackluster volume (orange line). And again in July 2008, we had a shallower price move with very poor volume levels:

William Hester of Hussman Funds did a very good historical analysis of volume characteristics during important market bottoms: Comparing Bear Market Rallies.

But there is an important nature of volume that I don’t think he took into consideration. Everything else being equal, volume tends to be cyclical and follow a pattern. For example, it tapers off during holidays like Christmas and New Years (yellow squares on the chart). Volume is light from June to August - what is referred to usually as the summer doldrums. And it spikes for panic lows (you can see a few examples above).

This makes analyzing volume patterns very difficult because we have to adjust for the seasonality. In any case, it is not really justifiable to give the spring rally some wiggle room for this because it doesn’t overlap with any important seasonal volume changes.