SERIOUS MONEY:Tepid buying interest calls the credibility of the market rebound into question

THE TWILIGHT Zone made its television debut on this day in 1959. The iconic television anthology created and introduced by Rod Serling began with the words: “There is a fifth dimension, beyond that which is known to man. It is a dimension as vast as space and as timeless as infinity.

“It is the middle ground between light and shadow, between science and superstition and it lies between the pit of man’s fears and the summit of his knowledge. This is the dimension of imagination. It is an area which we call The Twilight Zone.”

Stock prices appear to have entered this “fifth dimension”, as the record-breaking six-month advance of almost 60 per cent from the bear market low registered in March continues undeterred in spite of the contradictory signals emanating from both the gold and Treasury bond markets.

Valuation multiples on normalised earnings are back above historical averages, having spent just nine months below the long-term mean.

Advances of this magnitude from bear market lows have typically been accompanied by economic growth of 5 per cent or more and year-on-year profit increases above 30 per cent.

Today, the economy is just emerging from recession with paltry economic growth likely as far as the eye can see, while the corporate sector is set to report the eighth consecutive quarter of declining profits during the upcoming earnings season.

Equally, if not more concerning, is the fact that the bounce in stock prices has taken place in the absence of perhaps the most defining characteristic of sustainable market advances – a notable expansion in trading volume.

An analysis of historical trading volume and price data indicates that volume is the ultimate weapon of the bull and the strength of the advance off the bear market low has historically been dependent upon the trend in trading volume.

Indeed, the six-month price change from the bottom in each of the nine bear markets since 1957 exhibited a more than 70 per cent positive correlation with the percentage change in the four-week moving average of daily trading volume and the results are statistically significant.

It is clear therefore that rising prices and expanding volume go hand-in-hand off bear market lows.

The historical evidence indicates that major bear markets begin with heavy trading activity and bottom on listless volume as selling pressure is exhausted.

The initial decline in prices is usually moderate as continued buying interest from stale bulls lessens the downward pressure arising from increased selling. The large gains during the preceding bull market leads to overconfidence and misguided optimism that sees most investors dismiss the initial downdraft in stock prices and view the setback as a healthy development rather than the emergence of a new pattern.

Investors’ bullish convictions are shaken as fundamentals visibly deteriorate and the concern inevitably turns to panic as bearish characteristics develop. Selling pressure surges higher and given the absence of buying interest, prices fall sharply.

The negative price momentum typically sees trading volume increase for a time to levels that exceed the activity seen at any point during the preceding bull market. This selling climax arises from investors’ attempts to exit the market simultaneously.

Market prices bounce once the selling climax abates but on diminishing volume as investor enthusiasm wanes, which ensures that it is only a matter of time before the bear market resumes.

Volume picks up as prices fall to new lows but activity is less intense than the original selling climax. Prices rally once again but buying power remains limited and the advance is inevitably aborted.

The subsequent sell-off results in new lows but on diminished trading activity. This process continues until selling pressure is exhausted such that prices flatten out and bottom amid pronounced inactivity.

A new bull market inevitably emerges from the seemingly lifeless market as fundamentals exhibit a decline in the rate of deterioration and prices register a higher low. The initial rebound frequently exhibits a surge in activity relative to the paltry trading volume at the bear market low and importantly, the crescendo of activity is particularly pronounced off a secular bear market low.

The sequence as described has been evident at every major bear market low, including 1949, 1974 and 1982.

Indeed, the four-week moving average of daily trading volume jumped more than 50 per cent in the six months that followed the cyclical market bottom in October 1974 and almost 60 per cent from the secular low in August 1982. Volume increases of 20 to 25 per cent have been more typical during the first half-year of a new bull market.

Judged against the trading volume data apparent following previous bear market lows, the current record-breaking advance stands as an extreme outlier. The four- week moving average of daily trading volume has dropped almost 30 per cent over the past six months as the gain in prices has approached 60 per cent.

The historical data suggest that such an upward move would be expected to be accompanied by a more than doubling of trading volume. Yet the comparisons become even more troubling when one considers that the bulk of trading activity in recent weeks has been concentrated in a handful of beaten-down stocks including AIG, Bank of America, Citigroup, Fannie Mae and Freddie Mac.

Stock market indices have recovered almost 40 per cent of their bear market losses in recent months but the trend in trading volume is cause for concern and the tepid buying interest calls the credibility of the rebound into question.

The advance is nothing more than a cyclical rebound in an ongoing secular bear market but for now, Wall Street advances ever further into The Twilight Zone.

charliefell@sequoia.ie