Bear Market Turning Points and Trading Volume

While bull markets end with a bang, bear markets end with a whimper. Investors looking for signs of a turning point might well consider trading volume as an indicator. Relatively low trading volume indicates a market is bottoming out.

There is some science to this. Many years ago it was observed that volume growth was strongly procyclic with financial returns. This correlation showed up most strongly in annually sampled data, meaning that this indicator operates more effectively at longer investment horizons. Simply put, if volumes are growing sustainably, then markets tend to go up.

The corollary to this finding is that a low base volume today should be associated with a low asset price – that is, a bear market. When trading volume rises from this low base, so will asset prices, thus ending the bear market.

The economics of this behaviour are difficult to reason, since there is always a buyer and a seller in each transaction. One argument is that massive selling triggers the end of a bull market as investors rush to the exits simultaneously, in turn chopping prices. As the selling pressure exhausts itself out, trading volumes decline and the market consolidates at the lower price level. Subsequently, investors return to the market, pushing up both prices and volumes.

So, where are we now? Trading volume on the NYSE has dropped considerably relative to the levels experienced during August, but they still remain higher than they were a year ago. This suggests that the market bottom is getting close, but we are not quite there yet.