Sector Rotation at Rydex
Wednesday, May 5th, 2004 8:45pm EST
Asset Flow Merry-Go-Round
Bottom Line: Assets have recently rushed into the energy funds at Rydex, historically a sign that speculation is excessive.
With crude oil futures hitting new highs nearly every week, it continues to attract the attention of traders and the media alike. The futures once again hit new highs today, but some of the related stocks didn’t do quite so well, so I thought it would be a good time to show some interesting data in the sector along with a few others.
The Rydex family of mutual funds has several funds that focus on specific sectors, as well as general market index funds (which are the basis of our Rydex indicators). Two of their sector funds, Energy and Energy Services, have attracted quite a bit of assets in the past few weeks, and I think it may be instructive to look at other instances over the past few years when we’ve seen this type of money pouring into those funds.
The chart below plots the total assets in the Energy and Energy Services funds against the Philadelphia Oil Services Index (ticker: OSX). Instead of that index, we could have just as easily substituted one of the many ETF’s loosely based on the energy complex, such as OIH, IXC or XLE – while they have different component stocks, they have a high correlation to each other.
Currently, assets in the two funds are running at a total of around $200 million (though that will likely decline today). After combined assets in the two funds poked above the $200 million mark in 2000, the OSX declined 19% and 34% respectively over the period of a few months. Subsequent rallies in oil related stocks never brought the same enthusiasm from Rydex traders over the next couple of years, as total assets in the funds had a hard time breaking even the $150 million level (though they did drop below a total of $30 million several times, and each corresponded to a subsequent rally in the OSX). Since the assets are again approaching that $200 million mark, it appears as though the chances of a significant rally above the recent highs from here are small.
Monitoring the asset flows into and out of these sector funds can give us a grip on a market truism – retail traders (who make up the bulk of these fund assets) tend to jump into and out of “hot” sectors en masse at almost precisely the wrong time. While the asset flows tend to be concurrent with underlying market performance, meaning the money flows into sectors that are going up and out of sectors that are going down (which should be expected and is not unusual), it is when there is an asset fluctuation not justified by market prices that often gives us a clue that there is a dislocation between sentiment and price. Let’s look at a few examples.
The following chart shows assets in the Rydex Consumer Products fund versus the Morgan Stanley Consumer Index (ticker: CMR). The red arrows show those times assets in the fund ballooned skyward as traders rushed to put money to work in the group. Not surprisingly, the Consumer Index had great difficulty maintaining altitude thereafter. There are a few more arrows I could put on the chart, showing the same thing, but I wanted to highlight the true extremes.
There is another interesting aspect to this data, highlighted by the letters “A” through “D”. At point A, the Consumer Index was approaching its previous high in 2001. Even though it didn’t quite reach that prior peak, assets in the Rydex fund exploded upward (point B on the chart). This disconnect between reality and sentiment resolved itself as we would expect – the undeserved bout of optimism resulted in a very quick 10% haircut in the index. We’re seeing a similar situation play out now. While the Consumer Index is toying with its March highs (point C), assets in the Rydex fund have far outpaced what was seen in March (point D). While there are obviously no guarantees, this rush into the Rydex fund appears to be premature and there is a distinct danger it could end badly if the index cannot take out its highs.
On the other side of the coin, let’s look at a couple of sectors that Rydex traders seem to be abandoning in anticipation of further declines. First, the chart below shows assets in the Rydex Retail fund versus the S&P Retail Index (ticker: RLX). The green arrows show approximately the other times assets in the fund dipped to around current levels.
Even though the Retail index is a mere 3% below its all-time high, traders have shunned the Rydex fund in that sector, apparently fearing it is going through a topping process. While that certainly may be the case, as far as I can see the uptrend is firmly intact, and the pessimism appears to be unwarranted. While these traders seemed to have nailed the downtrend in 2002, on balance their behavior was in keeping with the contrary nature of these asset flows.
Lastly, we’ll look at the banking sector. The chart below shows total assets in the Rydex Bank fund and Rydex Financial Services fund, plotted against the KBW Bank Index (ticker: BKX). The green arrows highlight those times assets in the funds became relatively low.
Once again we see that these traders piled into and out of the funds at the wrong times. Plunges in asset levels tended to coincide quite well with imminent rallies in the Bank Index, and when traders were tripping over themselves to get exposure to the group, it invariably lead to at least some short-term pain. Anecdotally at least, I know there is a large amount of doubt about the financial sector based on the idea of higher interest rates, and these Rydex flows support the idea that traders are in some manner backing up that talk. However, considering the fact that the Bank Index is still hovering above its previous all-time high in 2001, it seems odd to me that so many assets would be so quick to leave that sector.
While these sector asset flows have been quite successful from a contrary perspective in timing the various extremes in some of the underlying indexes, I think it’s important to understand that the fund assets we’re looking at are absolutely miniscule compared to total market value. If all of these Rydex traders pulled all of their money out of the funds, it wouldn’t impact the underlying equities at all, so there is no reason why the indexes have to rally or fall when assets reach an extreme. However, I think the record is good of these traders being something of a proxy for wrong-way traders everywhere, and they continue to consistently bet their heaviest when trends are about to change.
If there is enough interest from subscribers, I can look into posting these sector asset flows daily to the site. If you would find it useful, please let me know.
Conclusion
Many of the broader market indexes have either been range-bound or are forming relatively tight volatility coils (a.k.a. triangles), with very little directional movement. We know that trend-less trading tends to precede good trends and vice versa, so it appears as though we are gearing up for a sustainable move in one direction or the other. From the readings we saw this past March, and how the market acted subsequently, it has all the earmarks of having formed an intermediate-term low – meaning we should not meaningfully violate those prices for at least several months. I don’t really have any solid reason to doubt that now, but honestly I don’t have a real good “feeling” about the way the market is currently behaving. They say that the best trades are the most uncomfortable ones to make, but right now I am most comfortable sitting on my hands and waiting for a more definable edge.
Jason Goepfert
President and CEO
Sundial Capital Research, Inc.
Disclosure: no positions
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.
© 2004 Sundial Capital Research, Inc. All Rights Reserved.