Weak trading levels have thus far not undermined the stock market's recent rally. But that doesn't mean that they couldn't.
Many in the financial media have latched on to the argument that the low-volume nature of the recent stock rally doesn't necessarily undermine it. After watching the stock market grind higher over the past two months, I must agree that basing investment decisions on volume has left many looking silly in the face of a strong bull advance.
Still, one of the most dangerous phrases in investing is "this time it's different." While there are periods when basic concepts of trading and market psychology seem to be out of line with reality, eventually they do make their way back. Think back to the end of the Internet bubble when price/earnings ratios were discarded in favor of "new economy" metrics. It only worked for a short few months.
For this reason, I must caution investors that volume does indeed still matter. And when volume does start to increase, it might be a sign of a turn in the market and not the signal that it is time to buy.
The bible of technical analysis, Edwards and Magee's Technical Analysis of Stock Trends, says this, "Volume is of the utmost importance in all technical phenomena." Although price action is the most critical of factors in charting, volume tells us the conviction of the marketplace.
Right now, the trend is up so we must say that stocks are bullish. However, low volume tells us that the conviction of the public to own stocks is lacking. Indeed, Carl Swenlin, of DecisionPoint.com, says, "it means that more people than usual are sitting in cash because of the global financial crisis." The small investor is not convinced that owning stocks is a good idea, even after a 70% rally.
Many might say that all of this cash is bullish for stocks as potential fuel. That may have been true in a market dominated by small investors, but today's market is dominated by institutions. And according to Alan Newman in his Crosscurrents newsletter, mutual- fund cash levels are at their lowest levels since 2004. In other words, institutions representing investors are not sitting on that much cash.
But is a lack of conviction really a bad thing? Should it matter how the market goes up if we are watching our portfolios grow?
The lack of participation by many different types of investors means that stocks are in the hands of fewer owners. There is no buffer against adverse news, and it would not take much to get that group crowding the exit doors.
A buffer, in the form of a relative balance of buyers and sellers with different time frames and risk tolerances, slows down reactions. In a well-diversified marketplace, a small selling event does not turn into a stampede.
Richard Wyckoff, master technician of nearly a century ago, referred to volume as the "cause" and price as the "effect," indicating that volume leads price. Changes in volume lead to changes in trend. Of course, this was not pinned down to a time frame nor did it take into account the anomalies of today's market. Near-zero interest rates and government stimulus programs certainly change the balance of buyers and sellers.
But the principles at the core of market analysis remain.
Look upon volume as a risk measure and not a trend measure. The more volume, the more widespread the bullish mood and the more orderly the market will be, both as it rises and as it turns. Low volume does not prevent rallies. It does make them riskier.
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