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2012 Rally: Stock Prices Up but Trading Volume at Record Low - What Does it Mean?

Simon Maierhofer

Any talk about a continuous bear market is about as popular as hemorrhoids. In fact, suggesting the presence of a bear market seems almost as socially unacceptable as talking about hemorrhoids.

But just because it's hidden behind a veil of silence doesn't mean it doesn't exist. In fact, the less Wall Street talks about a bear market, the more likely there are to be falling prices. Just think of April 2011 (shortly before the summer meltdown) or April 2010 (shortly before the 'Flash Crash').

Unfortunately, sentiment is no longer fail proof (we'll discuss why in a moment). The absence of any fear in December 2010 for example had no immediate consequences.

Fortunately, there are other measures and indicators to gauge whether this is a new bull market or a giant bear market rally. Here are some:

We know that price is the only thing that counts, but because price is often deceptive it tricks investors to move in precisely the wrong direction at the worst of time. The more you know, the more likely you are to call a 'price bluff.'

Trading Volume

Trading volume measures the enthusiasm of buyers and sellers and is a totally independent variable from price.

The first chart below illustrates NYSE trading volume. The gray bars reflect daily volume. I've added a 50-day SMA to smooth out the daily peaks and valleys and allow for an easier volume trend analysis. The 50-day SMA shows that volume peaked in August 2007 and has since declined.

>> click here to view larger chart

Obviously, the larger-degree trend for volume has been down. Particularly noteworthy is the drop in trading volume since the March 2009 low. Various stock indexes like the Dow Jones (^DJI - News), S&P (^GSPC - News), Nasdaq (^IXIC - News), and Russell 2000 (Chicago Options: ^RUT) are up more than 100% since March 2009. Trading volume, however, is down in excess of 40% over the same period of time. What does that mean?

In his book Technical Analysis Explained, Martin J. Pring explains the significance of this: 'Rising prices and falling volume are abnormal and indicate a weak and suspect rally. This type of activity is also associated with a primary bear market environment.'

Ouch, the long-term picture doesn't look good. What if we zoom in to the short to mid-term time frame? The second chart plots the S&P 500 (weekly bars) against a 5-day SMA of trading volume. We see that since the 2007 market top, stocks have rallied on extremely low volume (red arrows). Periods of declines, on the other hand, were accompanied by massive trading activity. Technical analysis 101 says that's bearish.

>> click here to view larger chart

Volume Abnormalities Explained

Lowry's has been monitoring buying and selling pressure for over 70 years and notes that contracting supply rather than expanding demand fueled the rally from the October low. The absence of demand rarely bodes well for prices (that universal law applies to baseball cards on eBay as well as German luxury cars and yes, stocks).

Demand would be dismal (and prices much lower) if the government (domestically and abroad) didn't artificially prop up prices. QE2 in 2010/11 in the U.S. and about 1 trillion euro worth of long-term refinancing operations (LTRO I and LTRO II) by the European Central Bank, have force-fed money into the market. Low trading volume is a dream for central bankers, as a little bit of artificial demand in a small market creates a bigger

splash than in a highly traded market.

Practical Value of Volume, Breadth and Momentum Data

Volume, breadth, and momentum indicators help evaluate price action. Think of them as an x-ray image that reveals developments hidden from the naked eye.

Slowing momentum or weakening breadth, are often precursors of a market top. If you like charting stuff, take a moment to chart the percentage of stocks above their 10, 20 or 50-day SMA and you'll see that more stocks are falling below short-term SMA's, even as the prices of broad indexes move up.

Fewer stocks above their SMA, means that rising prices are driven by a small number of stocks (can you say Apple?). A tell tale sign of a weakening up trend. To measure breadth, the McClellan Oscillator uses a formula to calculate moving averages of advancing, verses declining issues.

The Relative Strength Index (RSI) measures momentum of stocks. The RSI provides some valuable clues, especially since we are in a liquidity-driven momentum market.

In August 2011, the ETF Profit Strategy Newsletter predicted new lows based on a typical divergence between price and RSI seen at major market bottoms.

This expected RSI divergence was one of the reasons the September 23, 2011 ETF Profit Strategy Newsletter expected that: 'A bottom at 1,088 should spur a multi-month rally' and explained that: 'From its May high at 1,370 to its eventual low, the S&P will likely have lost about 300 points (22%). This kind of move validates a counter trend rally. The plan is to square short positions and buy long positions around 1,088. The rally, once underway, will probably re-inspire a certain degree of confidence into the market before it runs out of steam.'

Divergences Raise Red Flags

We currently see bearish divergences between the McClellan Oscillator and prices, and RSI and prices. While the S&P has recorded new highs, the McClellan Oscillator and RSI have not.

That's why the February 26, 2012, ETF Profit Strategy update warned that: 'A correction starting between 1,365 - 1,382 seems likely.' Even though the ensuing correction erased 18 days worth of S&P gains within a matter of just three days, this correction has come and gone.

The March 4 ETF Profit Strategy update warned that any decline would trigger a bullish low-risk entry and the March 8 updated stated that: 'Aggressive investors afraid of missing out on another lullaby rally may decide to go long after a move above 1,369.'

The overbought situation seems to have become more acute and free money and being afraid of missing out on gains seem to be the only reason stocks are bought. A break below support now could unleash an avalanche of sellers and send prices spiraling.

The ETF Profit Strategy Newsletter explains one additional factor that may keep prices grinding up for a bit longer (along with the associated up side target) and the one support level that - once broken - would likely cause a 2011-like collapse.

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