March 1st, 2010

OBV: Leading or Following?

Many indicators tend to imitate the peaks and troughs on price charts. But at other times, a divergence may occur as the pattern of the indicator differs from the underlying price chart. There are actually 4 possible conditions between a stock (or index) and a technical indicator:

When the indicator and the underlying price are moving in tandem, we assume the indicator is confirming the price trend and that trend will continue; nothing indicates a future any different than the recent past. But what if the indicator and the price/value move in opposite directions, what if they diverge? Is that a signal and what is the message?

If a stock is trending higher making peaks higher than previous ones but the indicator fails to do so, does that portend anything about the future? Alternatively, if a stock is in a down-trend but the indicator is not making new lows, what might that divergence indicate?

The recent action of the S&P 500 Index and the On-Balance-Volume (the cumulative summation of volumes on up and down days), the OBV indicator, raises some tantalizing questions (click on image to enlarge):

The OBV has been consistently trending up since mid-March nearly without pause, even through this consolidation beganning last September-October. Since the January peak, shares traded on days the market was down nearly equalled days the market closed up with the result that OBV stayed nearly flat even as the market declined 3-4%.

Most references say that this sort of divergence (declining prices and flat or rising indicator) is a precursor of higher future prices. The logic says that selling that had depressed prices will begin drying up and buyers will soon take control and drive prices higher. An alternative explanation might be that the buyers who decided to sit on the sidelines (like me) allowed sellers to drive prices lower and as they return will reignite prices to rise again.

All the references assume that the indicator is correct and prices will adjust in the direction of the indicator. But what if the indicator is wrong and prices are right? Then as prices continue to decline, OBV will begin to coincide again with the direction of prices as more sellers will begin to flood the market.

If you’re confused your not alone. I’ve always held to the view in the past that price follows the indicator and, with OBV holding firm, I must now take the view that prices will soon resume their upward course. As a matter of fact, we sort of began anticipating this in “Summers, 2003 and 2009: Market Similarities and Differences” of June 13, 2009 (note the OBV lines of 2003 and 2009).

The “coincident/divergence” measure doesn’t forecast when … it may again be in March as it was in 2009 and 2003 or we may have to wait until later in the year. But more and more I feel we’re slowly emerging from a “lateral correction”. That keeps me hoping and interested.

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  • Brady

    Guru, your observation is fair enough, however, historically, it's also true that when OBV made new highs, index could make new lows, for example, take a look at S&P 500 between Jan and Aug 2004.

    http://stockcharts.com/h-sc/ui?s=$SPX&p=D&st=2003-07-01&en=2004-09-01&id=p59671220347

    My gut feeling is that in 2010 S&P will retest 950-960 range within next few months which represents a 31.8% retracement just like NASDAQ did in 2004. I may be wrong.

  • Joe

    I must not be communicating. Divergence between price and obv expresses a leading indication … as your 2004 excellently underscores.

    The Index declined 9% (and crossed under the important 200-DMA issuing a false signal) over 6 months while OBV continued rising; this set the stage for resumption of the recovery and a huge rally beginning in September, 2004 culminating finally with the 2007 Financial Crises market crash.