Participation Too Low To Support Bear Market

by: Clif Droke

Participation in the U.S. stock market is low by historical standards.

Average daily trading volumes have been shrinking for months.

This lack of exposure to stocks will forestall a bear market.

We’ve all heard the Wall Street bromide, “Sell in May and go away.” This year, however, it seems that multitudes of investors apparently decided to leave the market several months early. Multi-month lows in trading volume and various investor sentiment polls suggest that retail investors are on the sidelines as fears over a weak global economy remain high. In today’s report, we’ll examine the signs which point to diminished participation and see how this supports a bullish intermediate-term (3-9 months) outlook for equities.

Despite several major indices being at, or just below, all-time highs there has been an amazing shrinkage in equity market trading volume since January. Trading volumes are near their lowest levels of the year to date and are not much above last year’s lows. Using data provided by Dow Jones Market Data, Mark DeCambre reported that the 10-day moving average of total composite volume on the NYSE and the Nasdaq has reached the lowest level since Sept. 12, 2018. Moreover, total trading volume is on its way to posting the lowest monthly average since last August.

Total U.S. Stock Market Trading Volume Source: MarketWatch

DeCambre quoted Matthew Bartolini of State Street Global Advisors, who observed:

For the New York Stock Exchange, there has been a bit of hesitation to have full participation in the rally…with a decent amount of people on the sidelines.”

Barolini said he believes one reason for the lack of participation in this year’s rally is because investors who missed out on the post-plunge rebound are waiting to see what earnings look like before jumping back into the stock market. While that may be the case, it can’t be denied that average trading volumes have been in decline for years. This has been attributed to the ultra-defensive mentality embraced by many retail investors in the wake of the 2008 credit crash. Even after 10 years of a rising market, the small investors just don’t seem able to trust the stock market. And so the waiting game continues for them as they remain on the sidelines and continue missing out on a historic bull market.

The most important takeaway from this observation is that because participation among retail investors is so low today by historical standards, a bear market can’t be expected right now. Bear markets are most likely to occur when participation among the public is at a maximum and short sellers are able to play off the public’s bullishness for an extended period. But when everyone is skeptical of stock valuations and commitments are few, downside moves in the market tend to be short-lived and quickly reversed. There is little cause for a bear market when participation is so limited among small investors.

Market technicians, meanwhile, are quick to point out that declining trading volume when stock prices rise can indicate a lack of market strength. Classical technical analysis teaches that a falling volume trend in a bull market implies the rising price trend will soon reverse since there isn’t enough demand to support the rally. This belief is too simplistic to be applied to today’s market, however, since it fails to account for the shrinkage in shares outstanding and the diminishing number of publicly trading companies in recent years.

What’s more, machine-driven trading volume and quantitative trading accounts for a growing share of trading volume. The greater efficiency of algorithmic trading systems, as well as the growth of passive investment strategies, also accounts for diminished volume. Indeed, the correlation between rising prices and falling volumes seems to be the “new normal” since 2009.

More importantly than overall levels of trading volume is the primary trend of cumulative advancing minus declining trading volume on the major exchanges. This indicator provides a much more accurate assessment of whether the trading interest in equities is to the upside or the downside. The NYSE advance-decline volume indicator (below) confirms that most of the trading volume in recent months has been to the upside, i.e. participants are more interested in buying than selling. Since most of the participants in the market today are institutions and professional investors, not small investors, the implication here is that this informed group sees something very worthwhile in the 3 to 9-month outlook. Otherwise we would be seeing more downside volume on the NYSE. Needless to say the following chart supports the bullish intermediate-term outlook for equities.

NYSE Cumulative Advance-Decline Volume Source: StockCharts

Meanwhile, an important sentiment indicator suggests a lack of commitment on the part of mutual fund traders. The graph below shows the Rydex Funds Nova/Ursa Ratio Sentiment Indicator, a valuable measure of retail mutual fund investor psychology.

Rydex Funds Nova/Ursa Ratio Sentiment Indicator Source: Market Harmonics

The above chart shows that the recent spate of worries resulted in a sharp drop to the zero level in the intermediate-term Rydex ratio last month. The ratio has hovered around the neutral zone for most of the last few weeks. A drop in the Rydex ratio is typically supportive of stock prices since it implies that fickle retail traders aren’t over-committed to the bullish case. It further suggests an outright lack of commitment among fund traders, with the implication that there’s a lot of sidelined money out there right now. Current readings in the Rydex ratio tell us that the hyper-enthusiasm normally seen at a major top isn’t present right now. That’s good news for the bulls from a sentiment standpoint and will keep a bear market at bay.

I would also point out that the internal momentum for NYSE stocks on an intermediate-term basis is still rising. This also serves to greatly decrease the odds of a bear market, since historically bear markets have always been preceded by lengthy declines in the 120-day rate of change (momentum) for the NYSE new 52-week highs and lows. As you can see in the following graph, 120-day high-low momentum is still quite strong and supports a bullish outlook for NYSE stocks.

Source: WSJ

In conclusion, a lack of participation among retail investors as reflected by falling trading volumes, along with rising subdued sentiment and strong internal momentum, should combine to keep a bear market at bay for some time to come. This combination of bullish factors even has the potential to produce another big rally in the stock market in the coming months, contrary to what many observers expect. The evidence also suggests there’s still plenty of cash on the sidelines that can be allocated to stocks and fuel a continuation of the uptrend in the major indices. In view of this, investors are still justified in maintaining a bullish stance toward equities.

On a strategic note, traders can maintain a long position in my favorite market-tracking ETF, the Invesco S&P 500 Quality ETF (SPHQ). I suggest raising the stop-loss to slightly under the $31.40 level for this ETF trading position on an intraday basis. Only if this level is violated will I move to a cash position in my short-term trading portfolio. Meanwhile, investors can maintain longer-term positions in fundamentally sound stocks in the top-performing real estate, consumer staples, and financial sectors.

Disclosure: I am/we are long SPHQ, XLE, XLF. 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.