This Isn't Worth Squat Right Now

For months, people have cited numerous reasons why the stock market's rally was doomed to imminent failure. Yet given how long the market has continued to rise despite those protests, it's hard to take some of the ideas that some professionals are citing as indications that stocks are going to cool off sooner rather than later.

For instance, one reason why bearish investors have been skeptical about the rise in stocks recently is that the volume of shares traded has fallen as of late. Although that theory has some intuitive appeal, conditions in the stock market have changed so radically over the past couple of years that volume no longer has the same level of reliability in predicting which way stocks are headed that it may have had in the past.

Why volume is important
You might think that trading volume would be one of the least important factors in a stock's price. After all, investors who focus on the long run pay far more attention to a company's underlying business activities over periods of years or decades, so whether or not a bunch of professional traders decides to buy or sell shares on any given day is almost completely meaningless to them. Some of the world's best investors, including Warren Buffett and Peter Lynch, have argued that daily stock fluctuations are meaningless to one's investing success.

Nevertheless, if you do pay attention to the microclimate of day-to-day stock trading, there's some basis for thinking that volume is important. Because Wall Street thrives on trading volume, it's in financial firms' best interest to encourage more trading rather than less. When demand for stocks is high, lots of trading results, and prices can rise along with that demand. When investors become disinterested in stocks, however, prices have to fall in order to encourage bargain-shoppers to get back into the market.

Right now, disinterest seems to be carrying the day. According to Marketwatch, share volume was down 20% in November from its average levels between March and September. Is that a sign that stocks are doomed to fall?

Volume anomalies
There are several reasons why you should be highly skeptical of any market indicators that rely on volume right now. The biggest reason is that total volume numbers have been skewed throughout the year by just a few most-active issues. For instance, take a look at these highly traded stocks:

Source: The Wall Street Journal.

On each of these three days, a huge fraction of the total volume of shares traded was in just two stocks: Citigroup and Bank of America. So while lower volume might indicate falling interest in those bank stocks, it seems like a stretch to infer from it that the entire stock market is due to collapse.

Perhaps more importantly, many of the stocks that have such high volumes are also at price levels that are extremely low compared to where they were in the past. All of the stocks listed above traded in the single digits earlier this year, and several of them are still in that territory. Yet they've also seen some sizable gains throughout the year, so that some of these stocks are actually seeing greater volume when you measure it by the dollar value of shares traded rather than the number of shares.

A closer look
For issues dealing with market internals, I like to turn to the experts at the Fool's Mechanical Investing discussion board. There, I found an interesting discussion of the recent drop in volume.

In particular, one member on the board did a detailed historical analysis of volume throughout bear and bull markets back to 1926. He observed that the recent bear market had an unprecedented spike in volume that is unlikely to return to more normal levels quickly. More importantly, he concluded that rising volume doesn't always indicate market strength, and declining volume actually leads to higher stock prices rather than lower ones.

Don't get fooled
Simple indicators like market volume are always tempting to use as a gauge of where the market is headed. But if you rely entirely on them without looking closely at all the supporting data, you can easily draw the wrong conclusions and make bad decisions as a result. Volume may be falling, but that doesn't say one way or the other whether the rally will end soon.

Adam Wiederman sees another bubble forming. Find out why it's going to burst in 2010 -- and what you can do to profit from it.