Tuning In the Volume
by Brian Pretti CFA, Contrary Investor. June 26, 2009
So, we find ourselves fast approaching the end of quite the eventful quarter for the financial markets, no? The markets have clearly discounted the fact that the world is not about to come to an end by any means. But it seems that as we look into the third quarter now the hard work begins. There is an old saying in the markets when contemplating the end of a bear that is transitioning to a new bull market. First comes price, then comes optimism, and then come earnings. As you know full well, given action and investor behavior in 2Q, we now have the price and the optimism. The hard part will be the earnings. Quarter end institutional antics are what they are. We went into this quarter with a lot of institutional investors meaningfully underweight risk assets. And it has been these very higher risk assets/sectors that have led the performance derby charge in 2Q. But the reality of current earnings and forward guidance lies dead ahead in the next three to four weeks. Of course we will have plenty of “beat the estimates” cheering going on, but it will be especially important to watch how the markets react to the earnings. As always, the key tell is not the news, but how the markets react to the news. Stay tuned as we do not have long at all to find out exactly how this will unfold.
But another key issue concerning market health has been on my mind for a good month or so now and that is the character and fingerprints of volume, or should I say lack of volume follow through. So what does life look like as we move into the second half of the year? Let’s have a look.
First, we know that in nominal share terms volume expansion as the equity market has moved higher has been lacking. But we need to dig deeper. Let’s have a quick peek at some very simple charts of NYSE up volume character and down volume character. In a perfect world, what we would like to see in terms of a healthy equity market is an expansion in volume as measured by nominal share count as well as up volume share count specifically. You already know that in terms of nominal share count, broad NYSE volume has actually been declining for a number of months on a trend basis. Not exactly a stat to warm the hearts of the bulls, but this has not been the first thoughts in their minds these days as the relative performance derby has taken center stage after a disastrous 2008. Unfortunately, when looking at up or advancing volume, the picture is a good bit worse than the weak nominal share count volume. In the chart below, to eliminate the noise of looking at daily up volume character, I’m using a very simple 15-day moving average (MA) of NYSE up volume. Up until the last few days literally, we have been looking at up volume on the NYSE as weak as anything seen since the mid-March lows of this year – the prior SPX price lows for the current decade. Weakness in the trend of up volume has been running completely divergent to price of the headline equity indices for the entirety of the second quarter.
Although this may seem a bit arbitrary, marked in the chart with red bars is each instance of declining 15 day NYSE up volume falling below the 650 level going back to 2007. Every single instance of this occurrence, with the exception of the November 2008 lows, was a warning sign of a deteriorating macro equity market to come. Will it be so again at present? We’re going to find out really soon.
For what it’s worth, I applied exactly the same relationship as shown above to the 2003 period in that so many folks are trying to corroborate current equity market character with that of the 2003 early bull market lift off period. As you can see in the top clip of the next chart, after an initial burst of accelerating up volume off of the significant 2003 lows, the 15-day MA of up volume again fell under the pull of gravity shortly thereafter. But two character points of that period stand out clearly in contrast to the present. First, the 15-day MA of up volume never fell back to the level seen at the 2003 price lows. And secondly, after the initial dip, up volume again reaccelerated almost vertically, ultimately going to new highs within two months of the interim low.
Although this may seem like nitpicking, in recent weeks not only did we return to the March lows of 15 day NYSE up volume, we modestly broke those lows before the recovery this week. So looking at 2003 early bull market fingerprints in comparison to current circumstances, we need to see the 15-day MA of up volume reacceleration in near vertical fashion starting very soon. Very soon. IF the 15-day MA of up volume falls back to or below the March lows in the near future on a sustained basis, I’d consider that quite the ominous sign for the macro equity market environment. In like manner, lack of reacceleration to the upside would call into question any further sustainable rally into 2H. I simply hope I’m looking at the right benchmarks and road sign markers in terms of the fingerprints of equity market volume character. Simply stated, new bull markets do not begin with anemic follow.
The next chart is perhaps a bit more ominous. Here we are looking at the relationship of up volume to down volume, again using the 15-day MA for consistency. We already know up volume character is weak, but the relationship of up to down volume shows us serious weakness. What caught my eye when looking at this relationship is that the ratio of up to down volume has been sequentially lower at each aggregate equity market low since November of last year. In November of 2008 this ratio hit approximately 2. At the March 2009 lows we saw a 1.4 reading. As of the middle of this week we hit 1, again using the 15-day MA numbers, before reversing higher with the Thursday rally.
Every single instance of this occurrence going all the way back to early 2007 was seen AFTER the aggregate equity market had already fallen and was heading closely toward meaningful interim lows. That’s not the current character of the headline equity market indices at all right now. Far from it. I consider this quite the stand out like a sore thumb divergence point. Once again, checking back in on the 2003 equity market lift off period, the relationship of the 15 day MA of up to down volume relative to the S&P stood in complete contrast to what we now see. At that time we witnessed higher lows in the up volume to down volume relationship as the equity market rose. 2003 showed us the fingerprints of underlying volume improvement. A character trait to yet make its appearance in our current circumstances.
I wish I could tell you my concerns about equity market volume character have abated over the last month. But unfortunately it’s quite the opposite. Can earnings announcement season act to reverse the trends we now see? We seem to have a head start on a reversal with quarter end institutional window dressing behavior. But we better hope this continues because the current fingerprints of equity market volume character are telling us to put risk management first, end of the quarter potential “mark’em up” antics not withstanding.
I'll leave you with two last charts that also have my attention as we move into 3Q. Time to keep an eye on multi-period or time frame relative strength. On a very short-term basis, it has been clear that momentum has been waning in the major equity indices as of late. I’m simply using the S&P as a proxy below. Relative strength tells the story of the momentum fade. Really for the first time since a few days after the equity markets bottomed in March, the 14 period RSI for the SPX has fallen below 50 as of late, popping back above this level Thursday of this week with quarter end window dressing seeming to have commenced. Important why? As a very short-term comment, it has paid to be wary of equities when the 14 period RSI has fallen bellow 50. Pretty simple stuff.
But that's not the whole story by any means. To get a sense of or corroboration point for potential intermediate term trend change we also have to check in on the weekly 14 period RSI. Above 50 is a bullish condition, especially in conjunction with the daily RSI view of life also being above 50. After a brief travel up and through the 50 demarcation line on the weekly RSI we're now falling back a bit. But take a look at the character of relative strength as the 2003 bull began. It stayed consistently above 50 for five quarters and pretty much went straight into overbought territory once it initially crossed the 50 demarcation line in the first quarter of 2003. So we need to watch what happens with these two different timeframe relative strength lines. For the current correction to be nothing more than a shallow dip, the weekly RSI needs to remain above the 50 barrier and the daily needs to get going north again.
So for now, we have the price and the optimism change in 2Q. Looking into 3Q, for the equity market to remain healthy and advancing, we need earnings, accelerating volume and relative strength. In conjunction these key indicators will light the way. It’s these fingerprints that will show us the true character and health of the equity market.
© 2009 Brian Pretti