Rondeau’s Technicals: ETF Volumes Misleading

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ETFs and technical analysis, used separately, are useful tools for investors. And their virtues compound when technicals are specifically used for trading ETFs. That said, sometimes there's a fly in the ointment, as a closer look at State Street Global Advisor's SPDR S&P Retail ETF (NYSEArca:XRT) shows.

Ray Rondeau First, let's look at the percentage change chart below, that begins with XRT's inception in June 2006. Everything seems normal when compared to the S&P 500. There's an obvious high correlation in movements between the two, as we would expect. It's also clear that from a price base only (no dividends), XRT has had strong relative strength outperforming the S&P 500 by approximately 13 percent over this time span.

XRT percentage change from June 2006

Our next chart is daily, and covers a period of about one year, showing classic backward-looking technical analysis. Here we can see that the price trended upward (A-B) in a relatively uniform channel and then based (or ranged), as we normally see, in a prolonged upward movement from points (B-C).

With no pronounced selling or major bearish technical breaches in this basing area, the price resumed its upward climb (C-D), the same distance as the previous run, as measured from points (A-B). From that high, the trend breaks ( D ), falling back to a previous resistance area at the $37 price level, where it is trying to stabilize in forming what appears to be a triangle formation.

From a pure price analysis we seem to be in an area of indecision, so standard procedure dictates that we look to other information for further clues to predict future probable price direction.

Bullish Volume Pattern - XRT

In this case, we'll look for clues in volume data, which is displayed at the bottom of our next chart. What immediately stands out is what appears to be a Bullish Volume Pattern between the price and volume (magenta lines). One of the rules of technical analysis in Dow theory is that "volume should expand in the direction of the trend," which means that volume should support the current momentum and movement of the established trend.

On this chart, prices have clearly fallen since May until now, but volume is not expanding, but rather has fallen. In technical analysis, that would be interpreted as a bullish signal insofar as the declining rate of daily "selling transactions" as time progresses, suggesting that the bearishness is diminishing in intensity.

So what's the catch? Where is that potential pitfall that I alluded to above that sometimes makes combining the value of ETFs and technical analysis a bit problematic?

XRT - Total Assets - May to July 2010

Data compiled by IndexUniverse.com might just provide the answers we're looking for. From the period of the end of May to the end of July, XRT's total assets fell $747 million-from $1.2 billion to just $453 million-an incredible 60 percent. There could be many reasons for the drop, from falling prices (less than 11 percent in this example), to sector rotation of funds, to investment dollars switching to similar ETFs or other investments with lower expenses or other perceived benefits.

A more likely scenario in this case might be that of a simple "pair's trade" that is reducing the total number of outstanding shares. This might involve a large institution shorting XRT, and going long a volatility-adjusted amount of another retail-focused investment that, relatively speaking, has underperformed XRT over a specific period of time. From my technician's point of view, the reasons behind XRT's drop in assets can be somewhat irrelevant. What is relevant are any changes in the number outstanding shares, and the effect that this can have on any technical interpretations.

In our case, this bullish volume pattern-the reduction in volume with falling prices that appeared on our charts-is an illusion. The falling volume that we initially interpreted as a reduction of the selling intensity that had bullish implications is much more likely due to the fact that far fewer shares of the ETF are now being traded than in the month of May.

In fact, some quick statistics support this phenomenon, in that from January to April of this year, the average daily volume for XRT was 24.6 million, and in July, the average daily volume dropped to only 13.3 million shares, a 46 percent reduction.

Obviously, changes in volume to a stable number of shares being traded are classically noteworthy, but changes in volume compared to a changing number of outstanding shares are potentially misleading. Unfortunately for the technician, this is camouflaged in the charts as the transient number of outstanding shares is not visible, and additional research for proper and complete analysis is necessary.

The implications here are clear:It's important for the ETF investor using technicals to be aware that the number of ETF shares is changing every day due to the creation and redemption process that is central to how exchange-traded funds work. The key is to realize that when the number of shares outstanding of an ETF changes dramatically, especially over a short period of time, it can greatly distort classic technicals-based volume analysis techniques and thus lead one astray.

Have a profitable week and remember always, "Keep it in Perspective."

Disclaimer: All data and information provided in this column are for informational purposes only, and should not be regarded as recommendations to buy or sell securities.

All charts created with TradeStation. ©TradeStation Technologies, Inc. All rights reserved.

Ray Rondeau is president of the Boston Chapter of The American Association of Individual Investors . When he's not trading using technicals, he presents to various groups on technicals and trading in New England and beyond. He can be contacted for presentation information at http://www.investorstein.com.

Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2010 Index Publications LLC . All Rights Reserved.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: D , XRT

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