Which comes first: trading volume or price trend?

To be sure, this question doesn't have quite the flair of the age-old question about chickens and eggs.

But many on Wall Street these days are nevertheless asking it. That's because stock market volume has been coming down (see chart below) even as the stock market has been rising. If the trend follows volume, needless to say, then the market's recent rally is on shaky ground.

I'm here to tell you not to worry.

My review of numerous research studies suggests that if volume does lead the trend (a big if, as I'll describe more in a moment), its impact is so weak as to be undetectable to the naked eye. It instead only shows up when complex econometric tests are employed, and even then the cause-effect relationship is incredibly weak.

In fact, many of the academic studies that did find that volume leads trend found that it existed in some countries' stock markets, but not all, and in some time periods but not in others. Other studies, employing different econometric tests, found just the opposite causal relationship. And many found no cause-and-effect relationship one way or the other. (A good review of both the theory and evidence on price and volume, from an academic perspective, is available here.) No wonder analysts are unsure which came first.

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What about the apparent correlation between low trading volume during the summer months and the seasonally-unfavorable six-month period that begins in May (a pattern known as "Sell In May and Go Away"). Since average trading volume between May Day and Halloween does indeed tend to be lower than over the other six months of the calendar, wouldn't this be evidence in favor of the notion that volume leads price?


First, as I detailed in a recent column, the "Sell In May and Go Away" pattern actually traces to just one of every four years -- the year of mid-term Congressional elections. And, yet, summer trading volume is below-average across all four years of the presidential cycle-a correlation that is hard to square with those who believe that volume leads price.

In addition, there are some months of the seasonally-unfavorable period that tend to have above-average volume. This is especially true of September, which nevertheless historically has been the worst month of the calendar for average stock market performance.

The bottom line? Don't conclude from this analysis that the stock market won't fall in coming weeks. It very well could, after all.

If it does, however, don't blame declining trading volume.

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