SERIOUS MONEY:The recent stock market rebound in the US should be treated with caution
US STOCK prices have jumped almost 40 per cent from the recent bear market low registered in early March, reversing nearly a third of the losses incurred during the savage decline that began during the autumn of 2007.
The rebound in market indices has been greater in both duration and magnitude than each of the previous five aborted rallies over the past 15 months and has seen prices exceed their 200-day moving average for the first time since the Christmas of 2007.
Cautious investors with significant cash positions are already feeling the heat and,should the market continue on its current upward trajectory, it will only be a matter of time before the stale bears are forced to take action. Careful analysis, however, is necessary to determine whether it advisable to chase prices higher.
The surprising magnitude of the rebound in market prices cannot be dismissed out of hand as it exceeds anything seen in the past 70 years but experienced investors will be aware that the picture is incomplete without a consideration of price and trading volume in combination. Volume is the ultimate weapon of the bull and the strength of the advance off the bear market low has historically been dependent upon the trend in trading volume.
Indeed, the three-month price change from the bottom in each of the nine bear markets since 1957 exhibited a 75 per cent positive correlation with the percentage change in the four-week moving average of daily trading volume and the results are statistically significant. It is clear therefore that volume matters.
Before analysing the trend in volume during the current market rebound, it is useful to distinguish between the diametrically opposite volume tendencies during bull and bear markets.
Bull markets typically emerge out of the pronounced inactivity of the preceding bear market.
The initial rebound often exhibits a surge in activity relative to the paltry trading volume at the
bear market low and, importantly, the crescendo of activity is particularly pronounced off a secular bear market low.
Indeed, the four-week moving average of daily trading volume jumped almost 90 per cent in the three months that followed the major market bottom in August 1982.
The setback that follows the initial market rebound is accompanied by diminishing volume as the temporary buyers’ strike is not greeted with a significant increase in selling pressure. Not surprisingly, stock prices resume their upward path once buyers return and the positive momentum leads to ever greater volume as more and more investors get on board.
Each intermediate advance takes place on bigger volume until a protracted period of heavy trading fails to produce a notable increase in prices. Buying power is exhausted and the decline that follows heralds the beginning of a new bear market. Bull markets begin with pronounced inactivity and end with a prolonged period of intense activity. Bear markets, however, start with heavy trading activity, though the initial decline in prices is usually moderate as stale bulls continue to purchase stocks.
Over-confidence arising from the large gains during the bull market means most investors dismiss the initial downdraft in stock prices and view the setback as a healthy development rather than the emergence of a new pattern.
Denial inevitably gives way to concern and then panic as bearish characteristics develop. Selling pressure surges higher and, given the absence of buying interest, prices fall sharply. The negative price momentum often sees trading volume increase for a time to levels that exceed the activity seen at any point during the preceding bull market. This selling climax arises from attempts by investors to exit the market simultaneously.
Market prices can be expected to rally once the selling climax abates but on diminishing volume, which ensures that it is only a matter of time before the downtrend resumes. Volume picks up as prices fall to new lows but activity is less intense than the original selling climax. Prices rally once again but buying power remains limited and the rally is inevitably aborted.
The subsequent sell-off results in new lows but volume continues to decline. This process continues until selling pressure is exhausted such that prices flatten out and bottom on listless volume. The current bear market has been notable for the number of failed recovery attempts just as technical analysis textbooks describe, but has parted from historical precedent in that trading volume has edged higheron every successive market low.
The perma-bulls will argue that this does not matter as the magnitude of the advance since the March low confirms that the bear market is over. However, they fail to highlight that the recent trend in trading volume has been troubling. The four-week moving average of daily trading volume has dropped more than 15 per cent over the past three months as prices have jumped almost 40 percent.
The historical data suggest that such an upward move would typically be accompanied by an increase in volume of more than 90 per cent. Buying interest is clearly tepid and the credibility of the rebound is in question. Investors would be well-advised to remain patient for now.
charliefell@sequoia.ie
