Volume

This is an area of stock market analysis which I haven’t included except occasionally up till now. In recent weeks, however, divergences between volume and price action in the market have become marked. So it’s time to look more closely at this important section of market analysis.

Many commentators have noted with some concern that the bull market since March in America has been marked by steadily declining volumes. This is anomalous. Rising volumes usually accompany a rising market. That makes sense. As the market rises, investors become more confident and more people participate investing more and more money in the market. But, declining volume usually is accompanied by a lack of confidence which results, in the end, in a declining market.

Well – that hasn’t been the case with the Australian market. As the market has risen, volume has risen. As the market has corrected, volumes have declined giving way to further market rises. That is, until the past few weeks.

Following is a chart of daily volumes since before Christmas. Various seasonal patterns are evident in the volume figures. Naturally, with many people on holiday, volume drops off over Xmas and New Year. No great significance should be attached to that. Also, every three months, volume spikes with options expiries. Again, no great importance should be placed on those spikes. Recently, total volume spiked with a huge overseas cross-trade in GPT. Again – this has no significance. It is, however, important to note the trends clearly evident from the moving averages. To put the volume chart into perspective, here, firstly is a line chart over the same period for the XAO.

Since mid-August, while the stock market has been on a rip upwards, volumes have been steadily declining. We now have a clear divergence between the chart of the XAO and the On Balance Volume Chart. (On Balance Volume is a running total of volume calculated by adding the day's volume to a cumulative total when the price closes up, and subtracting the day's volume when the security's price closes down. It shows if volume is flowing into or out of a security. When the security closes higher than the previous close, all of the day's volume is considered "up" volume. When the security closes lower than the previous close, all of the day's volume is considered "down" volume.) This divergence between the XAO and the OBV suggests that there is now more selling pressure than buying pressure in the market.

Dr Alexander Elder has developed a more sophisticated use of the volume/price relationship. The Force Index relates the change in price to the change in volume by multiplying the change in price by the change in volume and plotting the result as a histogram. I’ve developed my own version of this, by plotting an 8-Day and 21-Day Moving Average of the histogram independently of the histogram. In interpreting this chart, the most important line is the 21-Day MA (shown in Red on the chart). When it is above Zero, the bulls are in charge, when below Zero, the market is bearish. Other factors are divergences and break of trend line when the trend has been in place for some considerable length of time. (The 8-Day Line has other uses, which I won’t go into at this time.)

This chart has fairly accurately defined the following:

1. The post-Xmas 2008 correction into early March.
2. Rally One from early March into June.
3. The June-July Correction
4. Rally Two from July to mid-October.

The current break of the up-trend line from July is an early warning sign of a correction. A break of the Zero line would confirm.

To Summarise: The current bullish posture of the market is not being confirmed by volume studies. This doesn’t mean that the market must fall here. The American market has had a bull run without confirmation from volume. But one must wonder how much longer the bullish stance can be sustained without sustained buying pressure to push it up.