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ONE OF THE CHERISHED TENETS OF TECHNICAL ANALYSIS is that trading volume confirms price moves. But as the latter half of the rally from the March 2009 low shows, markets can rally without large volume when conditions are right.
Fast forward to this month, and once again we find stock prices starting to go up without broad participation by the public.
Like last year, can bold investors safely ignore the low volume in the belief that stocks can rise for months without broad investor support? Or was last year's rise on low volume an anomaly, the likes of which isn't likely to be repeated so soon?
I believe that last year was the anomaly and volume is taking back its rightful place as a key tool in the chart watcher's toolbox. If that is true, and I believe it is, then the rally we've seen this week will not have legs.
Investors should not assume that last year's performance changed the rules.
When I speak of rules, I mean that liquidity leads to higher stock prices. Normally, it is broad public participation, i.e. volume, that provides the fuel to keep a rally going. Last year, it was government stimulus taking the public's place.
While I cannot directly address the prospects for more stimulus, I can observe that resistance to more spending is growing. From a technical point of view, this suggests less frothy market sentiment and less desire to take risks. It shows up in the chart of gold, which refuses to back down. It also shows up in other "safety" assets such as Treasury bonds and the U.S. dollar, both of which had been rallying for months before their respective pullbacks this month.
Of course, there are more crosscurrents these days than we are used to having, from European debt problems to man-made ecological disasters. They can easily shake traditional relationships between asset classes, so we have to take short-term swings with a grain of salt.
But for the big picture, the markets are trying to revert back to their respective means where traditional market forces -- the public, for example -- matter. We may argue on degree, but we can agree that the markets are behaving more orderly than they did a year ago. And that means volume should be back on the analysis table.
With Tuesday's big 213-point rally on the Dow Jones Industrial Average, the market found itself back above two important resistance levels -- the highs of late May/early June and the 200-day moving average (see Chart 1). The market was trading flat in late-day trading Wednesday.
Chart 1
Some may label action over the past few weeks as a double bottom, or "W" pattern for its shape on the charts. When prices move above the middle peak of the pattern, theoretically the bottoming process is completed and a short-term rally is in order.
But this is where volume comes in. A breakout from a technical pattern is supposed to signify a significant change in market mood from indecision to bullishness. Investors theoretically flock back in to buy and that shows up in volume.
One look at New York Stock Exchange volume shows it has been falling for several weeks including the rally seen in the past two weeks. That small slice of time contained a pair of 200-point-plus upside days, and Tuesday, when the supposed breakout took place, volume was clearly well below average.
This is not a significant shift in market mood. It is more like an absence of sellers than an abundance of buyers.
To be sure, headlines can push prices around and short-term momentum can drive prices further than we expect. But with overall market conditions at least on the road back to what most people would call normal, we cannot throw out a key piece of the analytical puzzle as we were forced to do last year.
Volume matters. We may have to tweak it differently than we did before the financial crisis, but we cannot ignore it, especially as part of the overall picture. After all, technical analysts look at price, volume, time, momentum, patterns and sentiment as a package. Many of these factors such as heavy overhead supply (resistance) from seven months of choppy sideways trading loom large.
A rally under these conditions can fool us for a while. But without demand evidenced in volume, its sustainability is questionable.
Getting Technical Mailbag: Send your questions on technical analysis to us at online.editors@barrons.com. We'll cover as many as we can, but please remember that we cannot give investment advice.
Michael Kahn, mutual fund co-manager, author of three books on technical analysis, former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, also blogs at www.quicktakespro.com/blog.
Comments? E-mail us at online.editors@barrons.com
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