Wary of the Rally

In last evening's note I pointed out the suspiciously weak volume experienced during the impressive (price-wise) rally in stocks we're currently experiencing. Suggesting that we should be, well, suspicious about its sustainability.

Bloomberg global macro reporter Eddie van der Walt expressed the same sentiment in his note titled Bull Trap Lies in Stock Rally Backed by Light Volume this morning:

(Bloomberg) -- Low volume at the start of the recent stock rally suggests it’s a bull trap, not a journey to record highs, based on algorithmic analysis of 30 years of data.

• Momentum in the S&P 500, Dow Jones Industrial Index and Stoxx 600 turned in March, thanks to collective action by central bankers. Since then, the question in financial markets has been palpable: are the lows in?
• History suggests not. In eight bear markets across the three indexes since the 90s, the bottom was usually marked with a bang, not a whimper. Trading volume in the first 10 days of the turnaround on all but one occasion (the Stoxx 600 in March 2009) was at least 10% higher than the volume in the bear market as a whole.
• And that makes sense. If a groundswell of money is ready to overturn a bearish consensus, volume is likely to pick up in an epic tug of war.
• Across the series, volume below 110% of the bear-market average in the first 10 days of an advance correctly identified five false dawns, where the index rallied 15%, then continued to lower lows.
• Volume is, however, a reasonable prerequisite, not a sufficient condition. Heavy trading would have triggered 12 false positives, which suggests that the study is best used to negatively screen rallies.
• For the most recent S&P 500 bear market that started on Oct. 9, 2007 and ended on March 9, 2009, the total drawdown was 57% and average daily volume was 1,310,603,671.
• Yet the bear-market rallies in this period offered mixed signals, as summarized in this table: (click to enlarge)

• This year, all three indexes failed the test. The first 10 sessions after the local low saw average trading volume of ~98% the bear-market average for the S&P 500, ~94% for the Dow Jones and ~104% for the Stoxx 600.
• As with all statistical analysis, this data should be treated with care and seen in context. The sheer velocity of the descent -- the fastest in history -- has meant that volume is probably skewed upwards. Volatility begets volume.
• Yet conviction was stronger on the way down than on the way up, and that’s a worrying sign. More study is needed, but on volume alone, this bear market doesn’t appear to be over.