Sunday, August 3, 2003
We’ve now been in a trading range for 42 days, since June 4th when the S&P closed at 986. Since that time, we’ve lost a grand total of 4 points while gaining as much as 29 points and losing as much as 24 points.
Apparently respecting this trading range, for the past couple of weeks fund flow among the Rydex funds has been neutral, as traders have not been too aggressive with their bets in either direction. The chart below is the Rydex Enthusiasm Index, which shows us how aggressive traders are relative to how the market performs. If the Index is high, then Rydex traders have been putting money into bullish funds and/or pulling money out of bearish funds to a greater degree than they rightfully “should” be given how much the underlying market has risen.
We should expect the Index to gyrate around 0.00, which would mean that assets are moving into and out of the various funds in precise relation to how the underlying market indices are moving. This is true to form, as the mean value since 2001 is +.01 and the median is -.01.
This triangle formation is telling us is that in general, Rydex traders are not making outsized bets in either direction. When the market rises, bull funds gain about as much in assets as they should, while the bear funds lose as much in assets as they should as well. The same goes for when the market drops (only in reverse). You can see how this contrasts with mid-May, when a relatively small drop in the S&P 500 lead to a larger-than-expected drop in the Enthusiasm Index. This shows an unusual timidity among these market timers, which should change quickly once the range is broken.
While there haven’t been any sustained, aggressive bets made, assets have slowly been accumulating in the bear funds. Since June 4th, total assets in the index funds and money market have risen $462 million. $213 million of that went into the money market, while $350 million went into the bear funds and $102 million went OUT of the bull funds. This does perhaps show a little pessimism on the part of these traders, but it does not appear to be excessive according to a variety of measures.
The Commitments of Traders data this weekend showed commercial hedgers (i.e. the “smart” money) flip-flopping the changes they made the week prior, as they became more net short by about 8,800 contracts (they had reduced their net short position by about 8,100 contracts the week before). Small speculators (i.e. the “dumb” money) increased their net long position once again, adding a little over 2,700 contracts for the week ended this past Tuesday.
This week marks the ninth straight week that small speculators have increased their net long position, which is a new all-time record going back to the inception of this report in 1986. The only other period which comes close to this long of an unbroken streak is the period ending in December 1998. That streak didn’t lead to anything dramatic in the market, only a continuation of the uptrend off the October lows from that year. However, during that streak small specs only added 27,500 contracts to their net long position during eight weeks, while this time they’ve added 83,800 contracts during nine weeks, nearly triple what they did in 1998. Granted, total positions taken have increased from what they were in 1998. Currently, small speculators are holding about 228,000 contracts long and short, as opposed to 145,000 contracts in December 1998, an increase of 58%. Still, the current addition to small spec net long positions over the past two months is the greatest in history, on both an absolute and relative basis.
The biggest reason for this jump is the expiration of the June contracts. When those contracts expired, there was an immediate 99,000 contract drop in small spec short positions (long positions dropped by approximately 43,000 contracts). So, I don’t want to make it seem like small specs have been loading the boat on the long side over the past couple of months, because they haven’t. They just haven’t been building up their short position like they had been leading up to the June expiration. Since the June contract expired, small spec have actually decreased they long positions by 4,200 contracts, but they’ve decreased their short positions by 12,200 contracts, increasing their NET long position (i.e. longs minus shorts) by 8,000 contracts.
This record-setting nine week addition to net long positions by these small specs is due to short-covering or expiration of short contracts. From a contrary point of view, that may not be as bearish as an outright increase of long positions, but it is still a show of complacency by a group of traders that has been consistently wrong for a very long time.
With all the attention the bond market has been getting, many of you have asked me to give an update on what our bond sentiment indicators are saying. The most recent weekly release of the bond sentiment survey from Market Vane, Inc. shows that the CTA’s covered by that poll have switched their opinion greatly from what they were recommending in May. At that time, 87% were suggesting a long position in bonds, as opposed to only 37% as of a week ago. This level of pessimism is now comparable to what was seen at the major bond lows in 2001 and 2002. If we go back a little further and look at the last prolonged decline in bonds, which occurred from October 1998 through January 2000, then such low levels of optimism didn’t stop bonds from declining for anything more than a week or two. At the time, the bullish percentage stayed below 38% from May 1999 through February 2000, a string of 39 straight weeks of “excessive” pessimism. The bond market finally bottomed in January 2000 when the bullish percentage was at a decade-low 15%. So while the current pessimism exhibited by these futures traders is relatively bullish from a contrary point of view, particularly when considered in the context of recent history, from a longer-term perspective, it can get much worse and for a lot longer. You can now find a chart of the Market Vane bullish percentage for Treasury Bonds updated each week in the “Indicators – Bonds” section of the site.
Rydex traders in the bond funds are also showing some extreme pessimism, as the Juno fund (which has an inverse correlation to the long bond) has hit new record asset levels nearly every day. Nothing much has changed here since I last discussed it.
Put/call ratios on 30-year Treasury Bond futures have been heavily skewed towards call volume over the past week. For five out of the last six days, the put/call ratio has been below 1.0, and the 10-day average is now down to 0.89. I’ve said numerous times that put/call ratios on bond futures are not terribly reliable, most likely due to the sophistication level of the average bond trader. However, a dramatically declining put/call ratio in the face of a bond market plunge smacks of a bottom-picking mentality as traders try to position themselves for the “inevitable” rebound. I wouldn’t read a whole lot into these ratios, but it does not appear bullish for bonds.
Lastly, and perhaps most importantly, we are still not seeing commercial hedgers aggressively buying bond futures. In fact, quite the opposite is happening. For the week ended this past Tuesday, commercial traders went from a net long position back to net short, with a swing of 14,300 contracts. Small speculators, however, added 15,800 contracts to their net long position. This created a negative 30,000 contract swing in the “variance” between the two trader sets, which is certainly not something you would like to see when looking for a major low in bonds. Since 1986, we have not seen a major upward swing in bond prices when the variance between commercial hedgers and small speculators has been negative.
The chart below shows a 4-week moving average of the variance at each important low since 1986. The variance is simply the commercial trader net position minus the small speculator net position.
The average variance is +36,300 contracts. The current 4-week moving average is -5,792, which is considerably below not only the average, but also the minimum variance seen at other lows during this time.
Overall, we’re seeing significant pessimism from CTA’s, extreme pessimism from Rydex traders, possible bottom-picking mentality in the options markets and a futures position variance unlike anything seen at other major lows of the past 17 years. While it looks as though a few pieces may be in place for a bounce, I don’t see much that would suggest a major low in bonds is imminent. Obviously, this suggests that the most likely direction for interest rates is higher. Stocks and bonds have had a weakly positive correlation since the low in equities in March, and should that relationship continue, and bonds continue to fall, it bodes ill for equities. I’m neither an economist nor an expert in bonds or intermarket relationships, but I’ve seen enough to know that outsized, relatively unexpected moves in one market often spill over into others. With the derivatives market so incredibly huge, and global markets so interlinked, this move in bonds has the potential to create havoc with the global financial system, especially if it continues. I’m no Chicken Little, but I do believe this must be watched extremely carefully.
The broader market has not been able to rally (and hold it) despite a moderately oversold condition for about a week. This is a decent clue that the character of the market has changed, and it will become progressively more difficult for it to sustain advances. Despite some mild oversold breadth readings, I don’t see much that suggests the incredible optimism we saw leading up to the high in June has worn off to a point that the long side is appealing to me. We’re now close to the lower end of the recent trading range, once again setting up relatively good risk/reward long trades for purely technical traders. A break of that range should finally get some momentum going, and I would not be anxious to buy into that. My preference remains with the short side as long as we are under 1015 on the S&P 500.
- Jason Goepfert
Disclosure: long OEX puts
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.
© 2003 Sundial Capital Research, Inc. All Rights Reserved.