Dec 23, 2002

Historically, today was supposed to be one of the strongest days of the year. Although we started out that way, we once again were not able to sustain any kind of trend and we ended slightly down. Going back over those times where this positive seasonality "failed" the day after the Christmas holiday, I could not discern a consistent pattern of future activity. Logic would suggest that if we cannot sustain upside on a day like today, then that must be bearish. However, the data does not support such a statement, as the average return and percentage of days positive 1, 3 and 5 days after failures was not statistically different from successes. In other words, today's negative action does not necessarily bode ill for the short-term.

The Investor's Intelligence survey came in with a continued lack of bulls willing to throw in the towel. Apparently, this much-hyped positive seasonality effect is having an influence over investor opinion. I looked at data over the past decade to observe what happened other times we've declined around 4% over a three-week period, as we have recently, while the II bullish ratio remained relatively unchanged. Specifically, I looked at instances where the S&P declined between 4%-5% and the corresponding changes in the II bullish ratio. For the most recent reporting period, the S&P has declined 4.3% (from 936.31 on 11/29/02 to 895.76 on 12/20/02) and the bullish ratio has dropped just over 2 points (from 67.1 on 11/29/02 to 65.1 on 12/20/02). The goal was to see what happened other times when the market declined substantially but investors remained optimistic.

The Definition of Complacency...
	3 WEEKS LATER	5 WEEKS LATER
When optimism dropped more than now...
Avg Return	0.31%	4.47%
% Positive	78%	89%
When optimism dropped a little or rose...
Avg Return	(0.96%)	(1.88%)
% Positive	40%	20%
source: sentimenTrader.com

We can see from the table above that when we suffered a three-week correction of between 4%-5% and there was a greater than 2 point drop in the II bullish ratio (showing an increasing amount of pessimism), the following 3 and 5 weeks proved to be quite positive for the S&P 500. However, when we saw unrelenting bullishness in the form of a steady or rising bullish ratio, then the following weeks were not nearly as kind, and in fact were usually negative. Granted, the total sample size here is 15 events, so it's difficult to pull any significant conclusions from this, but I do believe that what we're seeing is a troubling amount of enthusiasm for a declining market. That is not a recipe for a significant upside reversal lasting many weeks.

Obviously, the intermediate- and long-term picture remains bearish. Shorter-term, I continue to see a lack of extremes in a majority of our models and indicators, which tells me to keep trading light in either direction. The only exception tonight is the price oscillator on the NDX, which hit an extremely oversold reading of 28% at the close. Anything under 40% can be considered extreme. We haven't seen a reading this oversold since October 4th, and early August before that. It would be rare to not see an upside pop of at least 20 points in the NDX sometime in the next two days after a reading such as this. With the positive seasonality (just a few more days and I will stop talking about seasonality for a while, I promise), I would expect a good upside attempt tomorrow or Monday, so I would look to play the upside (again, lightly) if we see some signs of price recovery. I continue to be very aware of the levels I spoke about a couple of days ago of 885 on the S&P and 1000 on the NDX, so I think it pays to watch those areas closely. If those levels break, I expect to see some quick and severe selling pressure to emerge.

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that I have a position directly affected by my market outlook. Although I take great pains to remain objective in my commentaries, I believe it is only fair that readers should know that I have taken positions in accordance with my market outlook.

I would like to discuss an indicator from the Rydex complex that I believe will prove to be valuable over time. I've always thought that when the majority (i.e. the public) recognized a trend, they would place their money in the highest-beta stocks or indexes in order to capitalize on what they think will be higher prices. For those of you unfamiliar, ''beta'' is a term typically used to show a stock's correlation with an index based on historical performance. For example, if a stock of a beta of 2, then if the S&P went up 1%, the stock should go up 2%. If a stock has a beta of -1, then if the S&P went up 1%, the stock should go down 1%. Most betas tend to be somewhere between 0 and 1, although many tech stocks have betas greater than 1, and "safe"' stocks usually have betas closer to 0. It is possible to have a negative beta (meaning the security will typically move counter to the index), which some of the Rydex bear funds have. As an example of what types of funds have certain types of betas, here is a sampling of a few extreme cases from the Rydex family:

FUND	TYPE OF FUND	BETA
URSA	S&P SHORT FUND WITH NO LEVERAGE	-1.01
PRECIOUS METALS	INVOLVED IN VARIOUS ASPECTS OF PRECIOUS METAL PRODUCTION	0.26
HEALTH CARE	INCLUDES PHARMACEUTICAL COMPANIES	0.27
TITAN	S&P LONG FUND LEVERAGED 2-TO-1	2.03
ELECTRONICS	INCLUDES SEMICONDUCTOR COMPANIES	2.42

To test this theory, I created an index from the Rydex information which compares the momentum of assets flowing into the highest-beta funds to the momentum of assets going into the lowest-beta (or negative beta) funds. Those funds which had a beta close to 1.0 were ignored. Also, the index is weighted by the beta of the funds, so that those funds with the highest beta get the highest weighting. This should serve to appropriately capture the amount of speculation flowing into the various funds, relative to each other. The index should spike higher if traders are buying funds with high beta and/or pulling assets out of low beta funds. This would indicate that the majority of the traders (or the majority of assets, anyway) felt that the market was headed higher and thus chose to put their money into the highest-beta funds. It would be a measure of complacency or optimism. On the other hand, if the index was low, then that would show a greater momentum into low-beta, or "safe" funds, and would be a relative measure of fear or uncertainty.

The chart below is a current two-year representation of this index. We can see that the spikes higher (suggesting a sudden surge of speculation) do correspond quite well with short- to intermediate-term highs in the S&P. The spikes lower (suggesting fear or a search for security) did not perform as well. I have several potential reasons for this, but as usual the ''why'' behind any indicator isn't especially important for our purposes.

I like the concept of this index because I think it has the capability to really reflect the psychology of the moment. For example, the highest spike on the chart - in March of 2002 - occurred when the general sentiment among traders was that we had suffered a retrace to the September lows, and were now ready to exceed the January high. When we approached that level, the beta chasers really took charge and shifted their assets into the highest-beta funds. When new highs didn't materialize, you can see that the momentum quickly shifted out of those funds. Likewise, in late October 2002, the talk was all about a successful retest of the July lows. When it appeared that we were going to exceed the Augusts highs (actually, we did on the Nasdaq), then the momentum once again flowed to the highest-beta funds, spiking the Beta Flow Index higher. Not surprisingly, lower prices soon followed.

Our current reading is exceptionally low, which would suggest a level of uncertainty by the Rydex timers. Our other Rydex measures are also beginning to swing to oversold, but aren't quite there yet. We certainly are NOT seeing a beta chase by these traders, anyhow, which is something of a relief to the multitude of bearish sentiment indications out there currently. I will keep following this index, and if there is enough interest from subscribers, I can post it daily to the site.

We have a real dearth of developments on the sentiment front this evening, continuing the recent streak. All short-term measures remain in neutral territory, and other than the seasonality, I don't see a clear edge from my vantage point. Christmas Eve has generally been perceived to be very positive, and in fact 8 of the last 10 occurrences have ended positively. 7 of the last 10 have exceeded the prior day's high, and only 1 (in 1990) exceeded the prior day's low. Those are pretty good odds, and that positive seasonality extends through the second trading day of the new year for all intents and purposes. With no other clear edge in site in the short-term, I wouldn't be excited about fighting this bias.

This will be my last commentary until Thursday, so I wish each of you a safe and happy holiday.