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More on Dow Theory; Question on Volume

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OIN SUBSCRIBER QUESTION

Some confusion over the last sentence in your 7/2 index trader article:

"The volume trend is still down, confirming the weak technical picture suggested by the fall below 37 when the trendline was pierced, making thechart picture decidedly bearish."

I thought increasing volume "confirmed" a move, in either direction, not declining volume?

RESPONSE:

I was speaking about On Balance Volume or OBV, an indicator invented to ferret out some important information from daily trading volumes. This indicator adds TOTAL volume in a plus direction on any day that the stock is up. Conversely, it deducts all daily trading volume on down days. The important thing is to look for direction. 

If declining, the OBV indicator is 'confirming' a declining trend, so to speak. If advancing; if the direction of the line is overall up, this line, this On Balance Volume (OBV) Indicator, is 'confirming an up move. The direction is up or down like price.

Whereas, as you say, volume, meaning daily trading volume will tend to INCREASE in the Direction of the trend. 

So volume can go UP to both 'confirm' an up or a down trend. The reverse is assumed to be true: volume will decrease in the OPPOSITE direction of the trend; e.g., tending to decrease on up days in a downtrend; tending to decrease on down days in an advancing or up trend. 

MORE ON DOW THEORY AND TECHNICAL ANALYSIS. 

From here, my Trader's Corner topic is a carry over from last week. This prior article can be seen online at OI website: the 6/26 Newsletter.

I said then that what came to be known as Dow Theory became applicable or became principle tenets in the art (never 'science') of technical analysis. 

There was a lot more that Dow contributed to market knowledge and understanding than whether staying invested in the market was warranted or not. 

What follows are the basic tenets of Charles Dow along with my thoughts on it. I should also tip my hat to the contribution of Robert Edwards and John Magee, who wrote what many consider to be the 'bible' of technical analysis, Technical Analysis of Stock Trends, for their descriptions and analogy to the "tide, wave and ripple" effect, although this did not originate with them. 

THE MARKET DISCOUNTS EVERYTHING
Dow determined which stocks; the ones making up his averages, best represented the overall market. Every possible fact and factor relating to the price of a stock within the averages is quickly priced into the current traded price of that stock and hence into the averages. This is because the traded price reflects all knowledge that exists about the company and its current and future prospects in terms of its earnings power. Even so-called insider information will show up in the price and volume patterns that can be seen by astute observers of the trading in that stock. This group will in turn act on that information and that activity will become apparent to an ever-widening group. This principle is even truer today, given the extremely rapid and widespread distribution of information that occurs on the financial channels and on the Internet. 

CYCLES OF BULL AND BEAR MARKETS HAVE THE SAME REOCCURRING PHASES The point I emphasis here is that the phases of both bull and bear markets, while different depending on whether its a bull market or a bull market, are similar in terms of two factors:- elative knowledge about the market - Investor sentiment (attitude) about the market that ranges from disinterested to indifferent to interested; with varying degrees of intensity within disinterested and interested

BULL MARKETS  
A bull market comes after a lengthily and substantial decline in stock values that comes about due to a downturn in the economy or a recession. Major market advances are usually, but not always, divided into 3 phases. These phases are marked by who participates in them and what they are doing in each phase. 

1. ACCUMULATION
In the first phase, there is accumulation or buying over a period of time, during which very knowledgeable investors with good foresight about a coming business upturn, are willing to start buying stocks offered by pessimistic sellers who want out. This group of investors will also start to pay higher prices as the willing sellers exit. The economy and business conditions are still often quite negative. The public, and this is mirrored by the financial press, is quite disinterested in the market, to the point of where owning stocks is very unattractive to them and they are out of the market. The people that got burned, so to speak, in the last bear market, are actively disgusted with the market. Sound familiar!? Market activity is modest at best but is picking up a bit on rallies, but this is mostly only noticed, if at all, by professional market participants. 

2. A STEADY CLIMB
The second phase is one of a fairly steady advance, but one that is not dramatic. There is a pickup in business and encouraging economic reports as an improving economy leads to a pick up in corporate earnings. This phase is also a phase where money can be made relatively safely, as technical indicators turn positive and there tends to be an absence of volatile trading swings. 

3. MAIN STREET ADOPTS WALL STREET
The third phase, which at one and the same time can both be highly profitable and quite risky, is marked by heavy public interest and participation in the market. The economic news is good during this period and suddenly front pages of magazines have articles heralding the new bull market. The new issue market gets going as the public now has an appetite for new companies. This is the phase where you will hear banter at parties about the market, how well so and so is doing in stocks and where market-related Internet chat rooms are quite active. Price advances can be huge and volume matches. The more speculative stocks continue to advance but it is here that the blue chip stocks of the most established big-name companies start to lag. Some sharp downswings occur among stocks that fall out of favor. Speculation remains intense as seen in increased option activity, the first-day closes of hot new issues and in the level of buying stocks on margin. The end of this phase is always the same, varying degrees of collapse. This can come after a year or two or even after several years has passed from the beginning phase.

BEAR MARKETS
The animal analogy is quite apt, as the bear can both be very fierce and unforgiving, or can just go to sleep for a long period. Bear markets can usually also be divided into 3 phases. That this does not always occur is seen in the 1987 bear market that was sharp and steep, but with the decline only lasting two months. After that, there was a slow gradual process of advancing prices during which some bearish sentiment built up and people swore off the market. This phase didnt reach the typical bearish extremes however; as within 7-10 months the Dow had recovered nearly half of its October-November decline.

1. DISTRIBUTION 
The first phase of a primary bear market tends to be a period of distribution. This really begins in the final phases of the bull market. It is the phase where selling begins by the type of experienced investors that didnt get overly swept up in the extremes in emotion and price at the bull market peak this group are the more investors with more foresight and a more balanced point of view. This group has the knowledge to understand that company profits have probably reached their peak and that the price multiples paid (P/E ratios) for those earnings are also at extreme levels. They began to sell or distribute stocks to the still eager and willing buyers. Volume of trading begins to slow. The public is still in the market heavily but may be a bit frustrated as the rate of increase slows down and not all stocks participate on rallies. 

The distribution phase is also one where people who are not usually in the market become buyers of stocks. A story that I used in my book (Essential Technical Analysis) is about a friend of mine who had always only invested in real estate. This person told me near the 2000 top that he had decided to buy some stocks, but had modest expectations he only expected or wanted to make 20% on his money. This kind of expectation for stocks that historically return 10% on average and had already been going up sharply for months, was the final thing that got me out of the market. 

I had noticed the froth in 2000 and that the volume was slipping and profits harder to come by. Then, my friends actions and comment became my shoe shine boy event referring to the famous story of Barnard Baruch, who one day got a stock tip from the fellow that shined his shoes. Baruch went and sold his holdings and said that when shoeshine boys are giving me stock tips, this was the time to sell. I was stuck by a similar occurrence in 2000 at Cantor Fitzgerald, where I was working in 2000, when I overheard one of our security guards on the telephone discussing his trading and going on about this and that stock in a very knowledgeable way like one of our floor traders. 

The distribution phase I already knew well, having been through two earlier ones before this last one. The first was in the silver and gold bull market and bubble of the mid to late-70s. In the final phase, I finally succumb to the siren call of this market and made an impulse buy of some precious metals. At least I can re-plate my silverware with the silver bars I bought. 

Then in the late summer of 86 I was the trader-manager of a stock index program at PaineWebber and had the sense to sell my positions on black Monday, but not the conviction to be short, where fortunes were made over a couple of days. (Actually the distribution phase had already completed itself by the preceding Friday and we were about to enter a panic.) The other side of my missed profit opportunity in not being short was that at least I was out - there were a lot of losses incurred, especially if investors panicked or traders had to sell to meet margin calls and didnt hang on for the ensuing weeks and months of recovery. 

2. PANIC SELLING
Panic is a major characteristic of the second phase of a bear market. Buyers become scarce, bids falls sharply and sellers become desperate to get out. The downward acceleration becomes extreme and a near vertical drop can ensue at first, after March 2000 in the Nasdaq, the decline was gradually, occurring over weeks and months although there were some sharp down weeks, especially in the beginning. But then in 2002 as you know, it got pretty brutal as the market went into free fall this became very much the phase of discouragement which well look at next. 

The decline goes on longer when there is very strong conviction about the continuation of the bull market that has ended already the investing public, in general, does not believe the potential severity of the bear market or how they will eventually react to it. The handmaiden to fear, so speak, is hope. There is a reluctance to take a loss in stocks, especially a sizable one. Better to hope for a recovery. This is the phase where people will make a point of telling you that they are long-term investors. Investors have become conditioned to stocks going up and will maintain their faith in a market rebound for longer than is warranted by facts. Hope springs eternal as is said. 

3. DISCOURAGMENT  
After the initial part of the decline sometimes the worst part of the decline and often where prices are not dropping so steeply often comes the point where the economy has stabilized. Here, there can be a gradual market recovery and a rebound in prices of the stocks of the strongest companies. Or, this may be a long period where the market trends sideways. This is the third phase and is marked by discouraged sellers as the market does bounce back (more typical of BULL markets). There are many that didnt sell in the panic atmosphere that had prevailed earlier and give up on stocks the so called capitulation phase. 

Selling in the discouragement phase could also be coming from those investors and traders who bought during and after the steepest declines as they thought stocks looked cheap relative the inflated values of the late bull market stage. What causes this discouraged selling is that the rallies arent sustained and prices sink lower. Theres an old analogy about the erosion of a bear market being like a faucet dripping. Such slow steady loss, over time, becomes buckets. Business conditions at this stage may deteriorate further. Certainly there is an absence of good news with corporate earnings as the economy slides further. Sound familiar? 

The stocks that were very speculative, in terms of their potential to make money, may lose most of the rest of the their value in this phase. There were many Nasdaq stocks that have lost 80-90% of what they had gained in the prior bull market, in the 2 years after the March 2000 top. Blue chip type stocks tend to decline more slowly because investors hold on to them the longest. 

A bear market ends when all the possible bad news has been discounted. And it after it ends there is often even more negative news that keeps coming. Keep in mind that the discounting mechanism of stocks is always also an attempt to look ahead, so stock values will reflect the expectations of what earnings could be when business conditions improve for example, about six months ahead. It also should be noted that no two bear markets are exactly alike. The 1987 bear market was amazingly short in time duration and could be measured in weeks, although the price declines were quite severe. Some bear markets skip the panic stage and others end with it as in 1987. Bear markets go on for quite different time and price durations. 

Of 13 years with significant declines in the 40 years preceding the March 2000 March 2001 market drop, some have had steeper sell offs in percentage terms then what we have seen to date at least in the Dow. If we measure by the Nasdaq Composite, the 2000-2002 decline to date has brought a drop from closing weekly high to closing weekly low of 77% - 1987s loss of 37% seems minor compared to this.

The key aspect to knowing how it all works that however steep the price swings are, such as was seen in spectacular last phase of the tech bull market run up of 1998-2000 keeping in mind the characteristics of each phase will help you keep a level head. You know what is coming when the excess phase you are in ends and you can prepare for it. Keep in mind also, that these descriptions were made over 100 years ago. I have added more up to date examples, but the essential nature of the market phase stems from HUMAN nature and this is the constant or what doesnt change much. This relatively unchanged human nature, ours and others, is what you have to deal with in the stock market and it benefits us greatly when we can see which market phase we are in. 

OOPS - out of time. I'll make this a 3 part-er if you can stand it. Tune in this day next week.

Good Trading Success! 

NOTE - 
Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Contact Support with 'Leigh Stevens' in the Subject line. 

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