Market reversals according to turnover

Through the years, analysis of the price by itself has been more popular with technical analysts than looking at price and volume in combination. Joe Granville made volume analysis very popular with OBV (On Balance Volume) and there are today many new indicators that look at turnover in all its aspects.

This essay deals with a market model that attempts to explain the relationship between turnover and the various stages of a bull bear cycle. The model is of particular assistance in explaining how price and volume behave near market tops and bottoms. This could be of value as Wall Street approaches what many believe to be a major blow-off and what subsequently should be a substantial correction.

Assumptions

We all know that prices rise when demand exceeds supply and that prices fall when the converse is true. Thirdly, when demand and supply is quite evenly balanced, prices tend to remain steady. These are truisms in the market place.

Yet few people remember to add " . . at the margin" when they mention these. Trading action takes place at the margin where buyers and sellers meet. Consider the following : if a stock last traded at $10 and there is a buyer for 1000 shares at $9.90, while the best offer is 10000 shares at $10.50, then the price is not bound to fall simply because supply exceeds demand a 100 times. Nor is there any guarantee that the buyer will rise to the bait and buy his 1000 shares at $10.50. A market needs willing buyers and willing sellers to be a market, else it becomes one big bore.

When we speak of buyers and sellers it will be in the sense of willing buyers and willing sellers at or close to the margin where trade is taking place. More accurately still, we will be referring to the number of shares on offer and being bid for, as a market where there are 10 buyers, each bidding for 1000 shares, and one seller with 10000 shares on offer is in balance, even though the people involved are in a ratio of 10 to 1.

Two other assumptions we will make are best illustrated at the hand of a simple model of a market. By 'market' we imply all the people who are interested in a particular stock or commodity, or perhaps all the people in a given sector, such as transport or the .com companies, or even all the people who show an interest in the NYSE or the Nasdaq. These people come from all walks in life and are not restricted in any way by age, gender wealth or poverty or where they are located. In the model the population of people who make up a given market – any market, small or large – are divided into four groups according to how they comply with respect to two criteria.

People in any market either own a share in that market or they don't; they are also either active or passive. People enter or leave that population from the wider environment either because they become interested in the market and join the population, or they lose interest and leave the market.

People who become interested in the market enter the population as non-owners. They are just passive observers who are in the process of deciding whether they should buy into the market or not.

When they become active in the market, it is as buyers who either take out an offer or place a bid at a specific price for a share of that market. If their bid is filled, they move across to the quadrant of passive owners of the market and become holders. If bids remain unsatisfied because the market is trading too high, buyers eventually return to being passive observers.

Holders become active sellers either when they exercise a stop loss or when they believe the market has moved far enough and it is time to take profit. Frustrated sellers return to being holders when the price drops away below their asking price, else they successfully sell their shares and return to being observers again, where the cycle had started.

In the later discussion it will be important to remember the existence of the reverse flows of frustrated sellers and disappointed buyers.

The earlier assumptions can now be restated as: the behaviour of the market price (as index or price) is determined by the relative populations of the two active quadrants, the sellers and the buyers. If these are about equal, the price is stable, while an imbalance will have the price moving either higher – relatively more buyers – or lower, if there are relatively more sellers (again implying number of shares rather than number of people).

Daily turnover in the market is also determined by the populations of the two active quadrants. However, in this case it is not the ratio between the two populations that determines how many shares will trade, or what the value of the turnover will be in dollar terms. It is the absolute volume at the margin of the smaller of the active populations that determines what the turnover will be.

If there is a bid for only 1000 shares on a particular day, then only 1000 shares will trade, irrespective of whether there are 10000 or 10 million shares on offer. Similarly, with only 500 shares on offer, only 500 shares can trade, irrespective of how eager and plentiful the buyers are.

In addition to the assumption about trading volume, we can make further assumptions at the hand of the model: In a rising market, owners of shares waiting passively – even if attentively! – for prices to rise to a level where they are tempted into taking a profit. Active owners in the seller quadrant are mostly on offer to sell at a price higher than the most recent trade. Also during a rising market, non-owners are more likely to be found in the active quadrant as buyers, where some eager buyers take out offers while the majority have bids at or just below the most recent trade. The latter move their bids higher as offers are taken out, thus raising the price, until they become frustrated at not getting their orders filled and they too simply buy at the bid.

In a falling market, some owners will be content to sit it through, while those that become active as sellers will have offers to sell at or just above the most recent trade. A few will sell more aggressively to the best bids. Non-owners will be sitting quietly as observers, waiting for signs of a bottom or a reversal that would tempt them back into the market. Relatively few buyers will be around. Typically, bids will be strung out, starting at or near the most recent trade to well below that price.

When the price moves mostly sideways, with supply and demand in balance, buyers and sellers tend to sit astraddle the average trading price with trade taking place at or very close to the last price while maintaining the average price for quite a long time. With trade taking place at the margin around an average, turnover tends to be a little below the longer term average for the share. Under these circumstances, any sudden and sustained increase in turnover usually means the sideways and directionless trend is nearing its end.

These are essentially the same as the well known assumptions about supply and demand mentioned earlier, except that now we have inverted the picture. Instead of saying that excess demand leads to a rise in the price, we have described the market behaviour that typifies a situation of rising prices, on the one hand, and falling prices, on the other.

We can now use this improved insight into market behaviour to examine the relationship between price and turnover during an idealized bear-bull cycle – something that can not be done with the conventional view that prices rise when demand exceeds supply, or fall when supply is greater than demand.

The bear-bull cycle

A sine curve is used as a smooth idealized bear -bull cycle. We begin at A, where it is already clear that the market has topped out and could be beginning a correction of which the magnitude is as yet unknown.

At this point there are a good number of sellers around, more than the buyers – otherwise the price would not decline. Yet there are still buyers who were disappointed on the way up when the price moved beyond their limit bids and who now perceive a chance of obtaining shares at their original limit prices.

As the price moves lower into the range of previously disappointed bids, buyers re-appear at these lower levels. After having topped out, volumes initially remain relatively high, compared to the longer term daily average turnover for that market. However, as the price continues to move lower, observers become negative about the prospects for the market and fewer observers turn buyers again, so that turnover decreases quite quickly.

Note that the whole discussion treats turnover or daily volume in relative terms for that particular market, so that it can be applied to any market, irrespective whether that market typically has high or low turnover.

By the time point B is reached, the bear trend is in full swing. Most holders are either settling themselves in for the duration, while desperate sellers each day take advantage of the few bids that do appear to sell on the bid. Volumes are generally quite low, in relative terms, while the price drifts gradually lower on the few trades that do take place.

As the price keeps on falling, holders become more and more concerned. However, this is also the time when observers, not having to cope with fear that the market is going to collapse completely and thus being more objective about what is happening, begin to think of doing some bargain hunting – bottom fishing!. As the price keeps falling, bargain hunters in fact enter the market all the time, but mostly in too small numbers to make a difference. Except to provide transactions that carry the price lower all the time.

At some point in time – while holders become even more concerned – the price has fallen far enough to entice a growing number of new buyers from the observer quadrant into the hunt for a bargain. Now an very interesting thing happens. As demand begins to pick up, the price starts to fall much faster than before! The decline speeds up at point C on the cycle chart – as shown in the next figure in greater detail.

It does not sound right that the price should fall faster as soon as demand improves, but the explanation is quite simple.

During a bear market much of the trade takes place on the bid. Bids typically come in at or below the last trade, which means a good many trades take the price a little lower at each trade. When bids begin to increase in number as observers spot a bargain, there is still a large over-supply in the market. Many sellers by now have issued instructions to "sell at best". With demand increasing, there are more transactions each day at or below the last trade; even with quite small changes from trade to trade, the overall effect is that the daily closing price dips at a steeper rate.

Of course, the sudden increase in the rate of decline really spooks current holders/sellers and more urgent requests to "please sell at best" are issued to brokers. At the same time, as the price falls even more, more and more observers see a bargain developing and come into the market as buyers. Seeing the price still falling, they also tend to bid below the last trade and so help to force the price even lower – on increasing turnover.

Soon, however, point D on the chart is reached. There are now really many buyers and turnover is very high as panicky sellers are getting out of the market as quickly as they can. Then, finally, it happens: a few disappointed buyers, who were getting scared of missing the bargain because their orders were not filled as quickly as they thought would happen, instruct their brokers to buy on the offer.

The first few such instances may pass unnoticed, but soon other buyers also find that to get their orders filled quickly they too have to buy on the offer.

Keep in mind that during this period of heavy volume, sellers are being taken out of the market to become observers, thus depleting the pool of willing and eager – or panicky! – sellers. At the same time, buyers get their orders filled and become complacent – if at first quite nervous – holders who now watch the market to see if they had done the right thing. So, as this process continues, a point is reached where for a short while supply and demand is in balance and the price does not react much either way.

However, the number of new buyers spotting a bargain grows larger and soon demand begins to exceed supply. More and more transactions on the offer take place until that is the only way to be sure of getting an order filled – and the price begins to move higher again.

During the first part of the rise, at point E, volume is still high. There were sellers who refused to drop their offers as the price kept on descending into the pits, but now that there is some improvement they feel quite happy at being wise enough to have avoided selling at the bottom. As the price rises to levels where their ego is massaged by this thought, they issue a selling order with a floor limit and are quite content they have missed the worst of the market when the price moves up and sale goes through. (Exactly the inverse of the buyers at point A on the cycle chart!)

Before long, however, sellers realize that perhaps it would more wise not to sell at all. They withdraw their bids and become passive holders again, waiting to see what the price will do. At about the same time, the price is giving red-hot buy signals on many technical indicators – RSI, Stochastics and MACD all give momentum buys and the traders pile into the market just as sellers begin to withdraw. The price continues to rise at a good rate, with turnover falling back to relatively low volume. (Point F on the cycle chart)

A sustained rising trend tops out and levels off or reverses direction for only two reasons: firstly, buyers begin to realize that prices are absurdly high and they stop buying above a certain point. In this case, the rising trend begins to fall off on reducing turnover for some time before widespread lack of demand causes the price to remain below its ceiling.

A second reason is when the price rises to a level where many holders begin to take profit. Rising supply then satisfy more and more buyers and move them into the holder quadrant from where they sit and wait for the price to rise to a level where they can take a profit. As the price loses momentum under the increased supply, more sellers decide that it is time to get out and soon supply rises to meet and fully satisfy demand, and the price levels off on high turnover. Soon practically all outstanding demand is satisfied and the first eager sellers to simply hit the bid rather than wait for the price to rise to their offers initiate the new down trend.

In the first case, the price levels off on relatively low or declining turnover and the price enters a plateau. If it rises at all, sellers enter the market and soon has the price back on level keel. If the price falls any significant amount, previously frustrated buyers are sitting ready to take up supply and carry the price higher again.

However, in the second case there are usually a substantial number of frustrated sellers around who would still like to get out of the market. At the same time, most willing buyers have already had their orders filled and they are now sitting as holders anxiously following events. It does not take long before keen sellers begin to hit the few bids that do come onto the market and soon the price is beginning to move lower. Volume that was still quite high just after the peak, now declines in preparation for the long haul down.

Which brought us back to point A, where we had started the discussion.

Putting the model to work

The model teaches us that there is a way to anticipate the bottoms and tops of sustained bull and bear trends – over any time scale, really – by examining changes in turnover and price over time. A warning that a bottom at the end of a bear trend could be approaching is issued by an increase in the rate of fall of the price, combined with a rise in the turnover. If increasing demand lasts through a reversal in the price, the signal is confirmed and chances are good that the price would begin a sustained rising trend.

Similarly, near the end of a rising trend there will be firstly an increase in turnover and secondly a flattening of the rising trend. If the price tops out on high turnover, the likelihood of a new bear trend is high enough for one to play safe and take cover.

Which means there are two occasions when changes in price and volume, observed in combination, carry an important message.

A: When price is falling steeply and turnover is rising substantially, followed by a reversal in the price, still on high turnover.

B: When a price rise slows down and tops out on rapidly increasing turnover.

A momentum indicator, such as MACD, is very useful at revealing the rate of change of a variable, which is exactly what we are interested in. In other word, to interpret market signals in term of the model, we need two MACD's – one for price and one for volume – and have them positioned so close to one another on the screen that the correlation of the trends on the two indicators can be compared.

The custom software I use has such and indicator, which we called "deltaP/deltaV" to indicate that it displays the rate of change of price and volume as one combined indicator. Readers who have technical software that can generate a MACD of volume in addition to that of the price, can place the two indicators one above the other so that occasions of say steeply falling price (price MACD well below the base line) in combination with rising turnover (MACD of volume breaking up through the base line) can be identified. It is usually better if the MACD's appear as bar charts, rather than line charts.

At the top of the market, a price MACD well above the base line and reversing lower to break below it, in combination with a steeply rising volume MACD, spells trouble. The price is likely to begin a significant correction or even new bear trend once the increasing supply has satisfied any remaining demand.

The above discussion dealt with an idealized example. True life is not as simple, yet the most price charts show a good correlation with the model. Good enough to generate very profitable buy signals, even though the sell signals are not always of equal high quality.

Examples:

The following two examples illustrate the model.

The daily price of SA Breweries – a brewer on the global market and large SA industrial conglomerate – is shown with an associated dPdV chart. The pinkish bar chart is a price MACD with the turnover MACD in blue. The MACD is a rate of change indicator. When it is above the base line (with value of zero) rate of change is positive and the price, or turnover, is increasing. When the MACD is below the base line, price (or turnover) is declining. The periods are about 7 and 15 days, which introduce a slight lag in the MACD charts relative to the price chart.

A: After a hesitation in a major bear trend (partly off-scale on left) bargain hunters step in on two occasions when the price falls again. Turnover jumps, but buyers are swamped by supply and the price resumes its down trend. During this whole period the price MACD remains negative – thus there is no signal of a trend reversal.

B: After a very brief flurry of buying a while earlier, which had no effect, more sustained buyer interest now has turnover rising and holding at higher levels. When this started the price MACD was still negative, as the model requires. Then the price MACD follows – also breaking positively through the base line to confirm the leading signal given by the turnover MACD. If the market model is correct, a trend reversal should be under way.

C: After the initial steep rise in the price – on lower volume! – the price corrects, but without a sell-off to trigger it. This is seen as still positive for SAB and is confirmed when new demand suddenly sends the price steeply higher.

D: Just a little increase in turnover is sufficient to end the final spike in the price. All buyers were taken out and when sellers wanted to take profit they had to trade on the bid – the price declines on much lower turnover (steep fall in blue MACD between D and E).

E: Increase in demand (blue MACD) starts while price MACD is still below the base line, to show that new demand has led the turnaround. When the price starts rising, turnover falls away again as sellers retreat from the market while the price keeps on rising to F.

F: A sudden and very steep increase in turnover ends the rising trend, but demand remains very high during the subsequent sideways trend and slight decline in the price – somebody was stocking up for the London listing of SA Breweries! Ditto at G.

H: After the terms of the listing is announced, the price takes off. At first on good new demand, but when the price reaches a double top (D and H) massive supply pushes turnover much higher and completely overwhelms demand. The price at first falls slowly, still on good volume, and then falls steeply as turnover – and buyers! – disappear. The party is over and the price should continue falling until a new surge in turnover shows that the bargain hunters are back.

The Dow Jones Industrial Index

A similar analysis is performed for the Dow Jones Index. Volume is turnover in shares. The time frame is a little longer than the example for SA Breweries. The chart begins with the end of the January –May 98 bull market.

A: The January-May 1998 bull market ends when a sustained rise in the volume MACD (blue) shows sellers coming onto the market in droves to quench all demand.

B: After a period of decline – no major sell-off – new demand appears, as shown by the rising MACD for volume. Note that at just this time, when the index had seemed to move higher, turnover increased and the index turned around and dipped steeply, exactly as the model predicts!

C: Turnover rose again steeply and the market peaked – supply was rising to dominate. However, demand remained during the fall in the index down to D and it seemed as if the buyers were still there in force – any moment now and prices would resume the rising trend.

D: Late August 1998 - The dollar suddenly much weaker against the yen. Yen-carry players flood the market with stock as they scramble to lock in profits and the Dow plummets. At the same time, massive PR by US brokerages ("Time to buy the dip!!") stimulates demand and the slide is halted on very high turnover.

E: A new surge in buying ends the new dip in the Dow and prices take off in a sustained rise - on lower turnover, just as the model predicts (MACD remains below base line).

F: The Dow tops out without a sell-off. Turnover did not increase markedly. According to the model, this indicates the market should move mostly sideways – finding resistance when it moves higher and support if it should fall – until the underlying demand/supply situation changes again.

G: When the market fell a little, a strong surge in turnover again signals good demand and the Dow begins a rise into a new high. Relative volume at first falls away, as expected.

H: The new high early in January this year, occurred and ended on a very steep increase in turnover - 401K buying, perhaps?? Hover, demand, indicated by still increasing volume, was sufficient to absorb the heavy profit taking going on and kept the Dow stable at slightly lower levels, (I), before supply and demand dried up.

J: The 10000 Dow beckoned and prices started to rise again, at first without a new surge in demand. Some profit taking as that key level was first reached is evident in the increase in turnover when the Dow first broke above10000 points.

K: After gathering reserves, the Dow has now broke well above the 10000 level. Over the past week turnover has jumped steeply.

The future: According to the model there are essentially two Scenarios. In the first, turnover falls away as sellers retreat back into holder stance because they realize the market is still bull. The Dow rises as far as demand can push it before sellers return in quantity to end the run.

The second scenario has holders becoming nervous and turning seller, keeping supply – and turnover! – at very high levels until demand is exhausted, after which the Dow tops out to begin a steep correction, or even a bear market.

Preference: Which of the two Scenarios it will be should become clear perhaps as early as this week (18-23 April). If turnover soon declines, as sellers retreat in the face of sustained demand and a strong Dow, the market could continue much higher.

However, if turnover on Wall Street remains very high as long as demand holds– which I suspect will happen – the long anticipated major correction could begin very soon.

20 April 1999

© April 1999 Daan Joubert
daanj@mweb.co.za

dPdV and deltaP/deltaV are registered marks