Where'd the Puts Go?

Bottom Line: Traders in lower-minimum shares have been more bullish than those in higher-minimum ones.

Most of our Rydex measures are somewhere between neutral and mildly overbought. At the moment, even with the S&P 500 hitting new closing highs (albeit in an ugly fashion), these traders have not shown their customary overzealous stampede into the bullish funds. That could change even with today’s numbers, but so far they have been behaving themselves to a greater-than-normal degree.

Most, if not all, services that report Rydex asset levels post the numbers as given by Rydex on their customer service phone line. It should be noted that the numbers that are disseminated are actually a combination of several classes of some of the funds. For each of the index funds, there are “C” class, “H” class, “Investor” class and in some cases, “Advisor” class shares. The differences between them are minimal, but there is some variance in their distribution. For example, if you open an account directly through Rydex and begin trading their funds, then you are likely in the Investor or H class shares. If you go through a financial advisor, then you may be put appropriately enough in the Advisor class. Lastly, if you buy the funds through a discount broker, like Schwab or E-Trade, then you will be trading the C class shares. I point this out because most of these shares have different minimum investment levels. If you open a regular retail account through Rydex, then you need to have at least $25,000. If you trade through an advisor, then the minimum usually drops to $15,000. And if you go through a discount broker, then the minimum investment in most cases falls all the way down to $2,500.

It may be possible to further isolate smaller, retail traders by concentrating on the C class shares. As noted, the minimum investment here is $2,500, and may attract traders with less available capital. Seeing if there is any substantial difference between these traders and the ones trading the traditional H or Investor class shares (which have higher minimum initial investment amounts) could yield additional insight into the behavior of these traders. This is NOT a perfect look, however, as there are many ways this data could be skewed. For example, just because someone buys the funds through Schwab does not mean they are a small trader, but they would still be in C class shares. Also, if you trade directly through Rydex, they only require $25,000 to open the account - you don’t have to buy that much of each fund you trade. It’s entirely possible that some, perhaps even many, of the trades in the Investor class shares are smaller than trades in the C class shares. Still, it’s at least worth looking at to see if there is some exploitable difference in the way these two groups of traders move their money.

My data on the different fund classes is quite limited, but I want to mention how this latest rally has been treated. Looking at the asset moves from 11/20 through yesterday, the table below shows how much money (in millions of dollars) the traders in each class moved out of bullish, long-side funds and into bearish, short-side funds:

	“C” Class	“H” or “Investor” Class
$ transferred	$57.0 M	$391.5 M
Total $ base	$296.9 M	$3,092.3 M
% of assets	19%	13%

We can see that investors in the C class shares moved a total of $57 million out of the bull funds and into the bear funds. The total amount of money in the funds was nearly $297 million, so we can say that they shifted just over 19% of total assets during this latest rally. On the other hand, Investor class traders moved $392 million out of a base of $3.1 billion, for a percentage shift of around 13%. Taken on the surface, this would suggest that those traders using the lowest-minimum shares were more aggressive in their bullishness than were traders in the highest-minimum shares.

As I said, I don’t have an adequate history on these segregated funds, so I can’t say whether this divergence between the two groups is significant or not. My initial impression is that it’s not – it’s much easier to see a change of 19% on a base of $300 million than $3 billion. I do think this type of analysis may have some use, and will continue to monitor it going forward.

Bottom Line: Option readings have lately been very tilted towards the bullish side, and now may spell trouble going forward.

I haven’t talked much about put/call readings lately, but if you’ve been monitoring them in the Indicators section, you know that one of my preferred measures has been stealthily creeping lower, and is very close to what could be considered a showing of extreme optimism. The 21-day moving average of the equity put/call ratio with QQQ options removed is now sitting at .50, one of the lowest readings seen in the past couple of years.

If we take a shorter-term view, the outlook is just as grim. A 5-day moving average of that same put/call ratio is now sitting at 0.45, again one of the lowest readings in the past couple of years. If we take a look at how the S&P 500 has performed in the past after such low put/call readings, it is not pretty. Five days after the 5-day average hit 0.45 or below, the S&P was an average of 1.5% lower, with a maximum gain of 0.7% and a maximum loss of 4.9%. That is striking, but even more troubling is this: out of the 19 days that showed such a low put/call ratio, the S&P was lower five days later every time except once (the aforementioned 0.7% gain). Another surprise? 17 of the 19 days have occurred since June of this year, a time when the S&P rallied approximately 10%.

It’s easier to see this in graphical form, so the chart below is a look at the 5-day average of the put/call ratio plotted against the S&P 500 for the period from June through today. The red arrows highlight those times when the 5-day average of the p/c ratio was at 0.45 or below.

Put/call ratios tend to bring out very definite opinions from most traders. Those who know options intimately, or who have worked at professional money management firms, usually express outright disdain for them, since they know what kinds of games are played (especially approaching expiration), and that there can be a thousand different underlying strategies. Say what you will about them, but this particular gauge has been spot-on this year. I never base trading decisions off of just one measure, but the history of this indicator is very good, and right now it is suggesting that any further strength, should we see it, will not last long.

Bottom Line: When industrials outperform tech for four days in a row, look for that trend to reverse.

Much attention has been given to the recent relative strength of the Dow Jones Industrial Average compared to technology benchmarks, such as the Nasdaq 100. As the Dow has been making new highs on an almost daily basis, the NDX has languished. For each of the past four days, the Dow has outperformed the NDX, meaning that it has either gained more or lost less on a closing basis every day for the past four days.

A streak of four days may not seem like much, but it is very unusual. Going back to 1985, streaks of four or more days of Dow out-performance account for only about 5% of all days. This is the seventh time this year that the Dow has achieved this type of feat. Looking at the six other times, on average the Dow then UNDER-performed the NDX for over 3 out of the next 5 days. Meaning, after four consecutive days of Dow out-performance, the trend switched and it was the NDX’s turn to out-perform over the next week. Over the next five days, the NDX out-performed by an average of 0.3% each day. I looked at this data multiple ways, and could not find any longer-term ramifications of Dow out-performance. Some extended periods lead to market tops, others market bottoms, others nothing but random action, and I could not see any consistent pattern.

My intermediate-term stance has not changed from Monday – I do not see a low-risk, high-odds opportunity on either the long or short side. I continue to believe that pushes to new highs will soon get pushed back, while smallish declines of 3%-4% will find buyers, at least through the beginning of 2004, and particularly if approaching the very positive seasonality we’ll be entering beginning next week.

Short-term, the oversold conditions I mentioned on Monday are gone, and we’re now very mildly overbought, though not to an extent that would have me wanting to be aggressively short right now. The put/call data from above certainly gives me pause, and it’s strong enough evidence that should we see another push higher that begins to falter, I would want to be looking short, at least for a trade. Don’t forget that volatility fell to a new 7-year low today. Most traders have stopped talking about it or wanting to hear about it (a sign in itself?), but history is littered with cases of quick, sharp declines when traders were least expecting it.

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.