What is Volume Telling us about the Stock Market?

These are times of unprecedented volatility in the financial markets, particularly on Wall Street. Not surprisingly, the recent whipsaws seen in the Dow Jones Industrials and the NASDAQ Composite index have left many traders on both sides of the camp debating which course the market is next likely to follow. A growing contingent of bears have been growling that the bull market is now over and that a crash is now imminent. Die-hard bulls maintain that the long-term uptrend is still in place and that the ultimate top has yet to be seen. Others predict a prolonged sideways movement in the market. Which side is correct?

In an effort to respond to these questions in a non-biased manner, and in an attempt at forecasting the market next major move, we are herein providing our take on the current market environment. Because of the enormous volatility that now exists on the major exchanges, it is becoming increasingly difficult—if not impossible—to accurately measure the market's pulse using conventional measurements (including price patterns, support/resistance, momentum, oscillators, etc.). It is such times as these that a far more useful tool is called for, namely, the interpretation of trading volume.

Volume is a greatly overlooked study by most financial analysts, even though many market observers seem to give much lip service to it. In our experience, there is no better gauge for measuring levels of investor sentiment, commitment/conviction and urgency. To use an analogy from the natural realm, volume can be likened to the tidal force of the ocean—the higher the tide, the bigger and stronger the waves; the higher the volume, the bigger and more meaningful the movements of prices.

Nearly everyone on Wall Street has noticed the lower-than-average volume that presently characterizes the market right now. But they seem at a loss to explain the meaning behind it. Some attribute the dried-up volume to portfolio managers at the institutional level, who are said to be satisfied with their current (supposedly net long) positions. Others attribute the low volume level to the belief that fixed income books are in trouble, and due to the fact that spreads hedging has dried up. As we shall see, however, while both positions have merit in some measure, both ultimately come short of explaining the current low-volume phenomenon.

Before delving further into our subject, we must understand some of the conventional concepts on trading volume and its relation to stock market interpretation. In our book, Technical Analysis Simplified, we wrote that "volume should increase—or at least stabilize—in the direction of the price trend. If the prevailing trend is up, volume should be heavier on the up days and lighter on the down days," and vice-versa for a downward trend. This represent the standard view of volume interpretation accepted by most market experts, and really all a part-time investor needs to know about volume. As we survey the price/volume configuration for the Dow, do we find the pattern referred to here? Yes, indeed we do, for volume in recent months has been most conspicuously heavy on the "up" days (those days in which the market closed at or near its intra-day high) and lighter-than-normal on the "down" days.

But more to the point, the prevailing price trend in the market for the past few weeks has seen a relatively even-matched show of strength among the bears and the bulls. A tug-of-war has ensued with both sides getting their share of the upper hand, but with neither side prevailing. In cases like this, where do we turn for answers? To the volume of trade. Trading volume has been uncharacteristically low for the past month now, even as prices have been declining. This reflects a lack of selling "urgency." What this likely means is that sellers have not yet gained an advantage in the bull vs. bear tug-of-war, for if they had, there level of selling would be noticeable in the form of increased volume even as prices would be dropping more emphatically than they have been lately. In short, the bears have not yet shown the kind of strength they'll need to turn the trend in their favor.

Another helpful maxim to remember in times like these is the old Wall Street adage which states, "never sell short a dull market." This refers, of course, to a market that has been strongly trending upward for some time, then suddenly experiences a setback but on lower-than-average volume. This almost always means the setback is nothing more than a temporary "correction" before the upward trend resumes. Such could easily be the case in our present market environment.

Yet another useful postulate on volume interpretation is found in another one of our books, Tape Reading for the 21st Century. In one of the chapters on volume in this book, we wrote, "Volume must be dissipated before a significant reaction or outright reversal can set in. What this means, simply, is that before a move in one direction or the other can run its course and reverse, all the volume that was necessary to propel prices must be sufficiently "used up." For instance, someone who is bearish on this market could not be full-scale bearish at the moment based on this rule since two of the high-volume spikes on the NYSE in the past two months occurred on upside closings (indicating accumulation). Hence, this volume must be "used up" before the market can begin falling to any considerable degree. Based on the immediate past, this could take several more weeks.

On the other hand, a stock market bull would have much to be bullish about (in the near-term at least) since another rule to be observed in these cases is that (quoting again from "Tape Reading"): "Volume must also be assimilated before an all-out move in one direction or the other can commence. This is particularly true when a stock [or index] has witnessed a huge spike in trading volume at or near a top…Even if it is concentrated selling, it normally takes several weeks, or even months, before an adverse reaction sets in carrying prices lower. This is because it takes time for all the volume to be properly "distributed" before the next major move can begin. At bottoms, this maxim also holds true, as big volume spikes at or near a price low—especially within a very narrow range—almost always represents concentrated accumulation. However, this accumulation typically takes weeks or months before the movement higher commences."

Looking at the major averages by themselves tends to be very misleading during times of consolidation. The proper method of interpreting the market is to break it down by its components. For example, when we look at several of the major "leading indicator" stocks (including Citigroup, Merrill Lynch, General Motors, and IBM) we can see signs that the general uptrend is still firmly in place—trading volume for these issues has been increasing on the upward movements and decreasing on the pullbacks, as it should. This technique yields valuable clues for where the broader market may be headed.

One of the best available measures of accumulation vs. distribution we have is a 5-day total of advancing volume on the NYSE. The exchanges provide investors with an invaluable service in providing daily total of advancing and declining volume, and it is a shame more investors don't utilize them (perhaps there would be less uncertainty as to the market's major direction if they did). When we look at the chart showing 5-day NYSE advancing volume, we see a surge in buying interest of Krakatoan proportions. Only two months ago, this indicator reached its highest all-time level, which indicates massive buying interest. This volume had to go somewhere, so if one wanted to argue that the insiders have sold out, we would definitely see it in the volume figures. The fact of the matter is, we have not. Until all this buying makes its appearance as heavy selling (as reflected in the volume figures), we must therefore conclude the market outlook remains bullish.

This is not to state that the long-term health of the bull market remains intact, for surely it is on its last legs. In fact, we believe the bull market could easily end sometime later this year (particularly as we head closer to the fall season). But for now, any attempt at selling short this market can be viewed as nothing short of suicidal.