Declining Volume Signaling A Trend Reversal For Stocks?

Includes: DIA, DXD, IWN, SDS, SPY, TWM
by: Larry Trefz

With the Dow Jones Industrial Average at all-time highs and higher for 10 days in a row, we continue to see declining volume. The decline in volume is not a recent development in this multi-year bull run in stocks. The general trend in volume has been significantly down through the majority of the rally that started in March 2009.

See volume at the base of the charts:

Chart forDow Jones Industrial Average (^DJI)

Chart forS&P 500 (^GSPC)

Does volume matter?

According to Dow Theory, volume does matter as a secondary indicator to confirm the trend:

According to Dow theory, the main signals for buying and selling are based on the price movements of the indexes. Volume is also used as a secondary indicator to help confirm what the price movement is suggesting. (For more insight, see Volume Oscillator Confirms Price Movements and Gauging Support And Resistance With Price By Volume.)

From this tenet it follows that volume should increase when the price moves in the direction of the trend and decrease when the price moves in the opposite direction of the trend. For example, in an uptrend, volume should increase when the price rises and fall when the price falls. The reason for this is that the uptrend shows strength when volume increases because traders are more willing to buy an asset in the belief that the upward momentum will continue. Low volume during the corrective periods signals that most traders are not willing to close their positions because they believe the momentum of the primary trend will continue.

Conversely, if volume runs counter to the trend, it is a sign of weakness in the existing trend. For example, if the market is in an uptrend but volume is weak on the up move, it is a signal that buying is starting to dissipate. If buyers start to leave the market or turn into sellers, there is little chance that the market will continue its upward trend. The same is true for increased volume on down days, which is an indication that more and more participants are becoming sellers in the market.

According to Dow theory, once a trend has been confirmed by volume, the majority of money in the market should be moving with the trend and not against it. - Investopedia

Basically, declining volume against a bull market makes the likelihood of a trend reversal higher. In other words, it will take less to turn the market negative as the sellers can much more easily outnumber the buyers.

With the S&P 500 bumping up against triple-top resistance, the importance of having sufficient buying volume to carry the market through the resistance is clearly important to the direction of the market from this point.

Should the market fail at these levels, it would stand to reason that we could be in for a significant correction given the length of the recent run without any serious pullback.

ETFs that can be used to trade the U.S. equity indexes include: (NYSEARCA:SPY), (NYSEARCA:SDS), (NYSEARCA:DIA), (NYSE:DXD), (NYSEARCA:IWN), (NYSEARCA:TWM)

Please remember that levered ETFs are designed for short-term trading.

Disclosure: I am short SPY, IWM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.