Sorry, Volume, I'm Just Not That Into You

03/25/09 9:10 AM EST

Good Wednesday morning...We begin the day with flat futures, which are about in the middle of their overnight range.  A surprisingly strong Durable Goods report wasn't enough to goose us much, and we still have the Home Sales report later this morning and the GDP report tomorrow.

I'm not a grouch by nature.  I'm a pretty easy-going guy (except when it comes to competition, to which my wife will attest).  For the most part, I would consider myself a "realistic optimist".

But there are a few subjects that get me riled up - politics (or politicians, more accurately), religious intolerance, anti-meritocracy...and volume.

OK, maybe volume doesn't quite fit with those others, but it's a sore spot with me.  I literally cannot count how many references I've seen over the past two days regarding Monday's "poor" volume showing, and how that means we really haven't bottomed.

Every one of those statements - every single one - was simply someone's opinion based on what it says in some decades-old technical analysis book.  None of them were supported by even a poor attempt at quantifying and testing their assertion.

We've done this several times over the years, but let's do it again.  Let's look at every major bear-market bottom since 1960 and look at total NYSE composite volume from the month before the low to three months after.  Then at least we'll have some basis in fact.  The red line in the volume plot is a 3-month average.

First, 1962:

Wow, look at that.  Volume was extremely heavy leading up to the low, then dried up as the market was rallying.  But wait a minute - according to almost everyone, this is impossible - the market cannot bottom on lower volume!  Puleeeeze.

Here's the next one, from 8 years later:

Once again, volume was very heavy heading into May and the eventual low.  It was above average in the two weeks following the low, but only two of those days showed volume spikes that were higher than what was seen during the decline immediately prior.  Soon after, volume dropped off precipitously, no doubt causing a furor among technicians pointing to "evidence" that buyers were no longer interested and we were doomed to hit lower lows.

Next up, 1974:

In 1974, we witnessed a more classic volume pattern.  Volume was high during the decline, but then really picked up as the S&P bottomed in October.  For the next month, only four days showed below-average volume as prices shot higher.  It backed off along with the market during November/December, and didn't pick up again until late January the following year.

Now another 1970's bottom:

This is an interesting one.  The 1976-1978 bear market wasn't particularly severe in terms of the pace of price decline, but it was a wicked grind-out, wear-you-down kind of market that just kept sliding month after month.

That was reflected in the volume pattern, as it wasn't particularly high leading up to the bottom or immediately after.  It wasn't until mid-April, more than a month after the bottom, that volume finally started to increase significantly.  But when it did, it did so with gusto and stayed high for more than a month.

Next, the most classic volume pattern the technicians could ever hope for:

In 1982, we saw an absolutely textbook example of how things are supposed to unfold (perhaps it tells us something that out of all of these bottoms, only one really fits the pattern of what we're "supposed" to see...).

Heading into August that year, volume continued to dry up as prices declined.  Supposedly, that meant that there were fewer and fewer motivated sellers, and we quickly saw a change in character during the initial price rise.  As prices shot off the bottom, volume surged dramatically, doubling and even tripling the levels seen immediately prior to the low.

Volume stayed extremely high throughout the initial part of the rally, backed off as prices did during late September, then surged again along with price in October.  Absolutely classic.

Now the most recent example:

October 2002 was a little different than all the rest.  Volume was high - at least higher than average - in the weeks leading up to the bottom, then backed off gradually as prices rose out of the low.

The highest spike in volume around that low was October 10th, the day of the bottom, but subsequent to that we never saw volume that was greater than what we saw in the days of selling pressure leading up to the low.  The highest spike of all on that chart occurred on November 21st, a big up day.  I suppose that got technicians all excited, but I'm not sure why, since it pretty much marked the peak as we slid into March 2003.

For comparison's sake, here's our current situation:

Out of all the precedents, this is probably closest to 2002.  Volume had dried up a bit in the months leading up to the low, then picked up substantially during the final few weeks.  It stayed high after the low.

But our current juncture is different in that we've already seen three days with volume higher than what was seen before the low.  And so far, every day has witnessed volume above the three-month average, most by +25% or more.

There isn't much I can see from these historical examples that suggests what we're seeing now is a classic sign of bottoming behavior.  But there isn't much that's "classic" about any of them, except 1982.  That was a picture-perfect example of what's supposed to happen, but out of all of those major bottoms, there was only one clear instances that would have signaled - in real-time - that we were likely bottoming, according to the volume pattern.  The rest were either inconclusive or outright non-supportive of higher prices according to the textbooks.

Total market-wide volume can be useful at extremes, but waaaaay too much time is wasted on dubious concepts like "accumulation" and "distribution" days.  For the most part, we tend to see heavy volume heading into a low, heavy volume immediately thereafter, then a drop-off as prices stabilize and head generally higher.  We haven't seen anything so far this month that would negate that pattern.  Personally, anytime I read a quote about the "low" volume we're seeing now, I'd skip to the next section.

Bottom line - Intermediate-term

Two weeks ago, we went over a number of indicators and studies that suggested we were very likely within days of an inflection point.  By Tuesday and Wednesday of the week before last, sentiment had reached an extreme (the setup) and the price pattern coincided almost perfectly with past lows (the trigger).

The market failed to follow through immediately, instead continually flirting with that 681 area that marked March 3rd's late afternoon low in the futures.  Despite intraday forays under that level several times, we closed above it every day but March 9th.  This was a messy pattern, but still basically within the confines of the risk parameters mentioned in the past studies.

After March 10th's "blast off" day, we needed to see some short-term follow-through, per the tables from Wednesday and Friday.  We got that in spades, which basically means that it would be unprecedented to not see generally higher prices over the next one to three months, and pretty much everything we've looked at since then helps confirm that outlook.

The short-term prospects have been more difficult to determine.  Last week, especially, the S&P was able to rally better than expected, only temporarily being rejected by resistance levels.  Now we're in a kind of vacuum as far as that goes, with 875ish the next clear area of probable trouble.  The good news is that this rally has now generated several areas of support, layered from 730 through 760.  From here, I'm looking for a broad multi-month trading range to form, bordered between 730ish at worst and 875ish at best, and will be looking to buy/sell anywhere near those respective levels.

Bottom line - Short-term

Yesterday I mentioned that a day like Monday will trigger all kinds of extreme readings, and we're certainly seeing that according to a number of different guides (such as the 10-day Up Issues Ratio, the Equity Put/Call Ratio and Rydex traders).

That pushed the Short-term Indicator Score outside of its upper trading band, and again the market had trouble sustaining higher prices as a result.  But the two other times that has happened since the low earlier this month, the S&P was bumping up against resistance at the time and the subsequent weakness was quickly reversed.

I don't see that same kind of resistance here, in fact the way I view things I can't really find any kind of confluence until we near 875ish.  I would certainly look to sell or short should we approach that area into early April - assuming we see a plethora of overbought signals at the time, which should be a given.

Despite a handful of overbought readings, however, most of our indicators were not very stretched after Monday's session and since we weren't really at resistance either I couldn't find a high-probability reason to bet against the rally.  Likewise, I couldn't find any good reason to chase prices higher either, as that's rarely a good idea after a 6% one-day and 21% two-week rally.

As we try to consolidate Monday's moon shot and let our indicators sort out, I'm not doing much on a trading basis.  The Dumb Money is starting to creep up, but not yet near troubling levels, and our shorter-term guides are neutral for the most part.  In the be-careful-what-you-wish-for department, ideally we'll see prices continue to back off for a couple of days so the overbought readings we do have return to a more normal state, and perhaps we could even generate a few oversold ones.  There are now several layers of support underneath, so that should help set up a long trade heading into April, which has been the most positive month other than November and December.

All the best,