Investing In Shares

Watch Volume Not Price During Bubbles

When it comes to investing most people only focus on price.

However a market price is found through the process of finding equilibrium between the supply (sellers) and demand (buyers) of goods, services or assets.

So volume of transactions can be as informative about a market’s strength as price itself.

Volume can become particularly important when an asset price rises well above fundamental/historic value (ie the investment has turned speculative).

Once an asset’s price rises beyond the point where its operating revenues do not cover its operating costs then the investors is justifying the purchase of the asset on the assumption of further asset price appreciation or on a improvement in the asset’s operating cash flow in the future.

Usually for prices to rise further beyond this point of negative cashflow it requires an increasing number of buyers willing to ignore the fundamentals with an increasing level of optimism about the future.

However, if price appreciation begins to slow on falling volume this is usually an early warning sign that the market is struggling to find new buyers to buy into the theory of the investment being a sound one in spite of the negative cashflow.

At this point those who invested knowing that they were going to lose money in the short run because they believed prices would continue to rise may opt to sell their investment as prices begin to fall, which increases the number of sellers (supply) and has the effect of pushing prices down even further which encourages more speculators to sell in what becomes a self reinforcing bubble collapse.

If the asset prices are well above fundamental or historic norms then prices may need to fall a lot before fundamental buyers (who invest because the future cashflows justify the price) will step into the market to buy.

This price and volume dynamic is present in most liquid markets that lend themselves to occasional irrational bubbles, be it shares, property or bonds.

Yesterday I posted about the entire Australian housing market transactions falling to their lowest levels on ABS records. To offer some examples here some price and transaction charts (by CoreLogic) for some Australian mining towns in recent years:





The same dynamic can be seen in other nations markets, ie the US housing market during its bubble when volumes of sales peaked in late 2004, but prices peaked in early 2006: