Back Near Top of the Range
Sunday, June 13th, 2004 9:45am EST
Leisure, Basic Materials: “Where’s the Love?”
Bottom Line: Rydex traders are showing their colors in the sector funds, with consumer products stocks perhaps getting more respect than they should, and entertainment and industrial stocks getting none.
In a choppy market environment, there are still many ways to make money. I’ve talked before about concentrating on oscillating indicators to time the movements within a trading range, but another way is to shift your focus away from the broader market and instead concentrate on sectors. With the rapid introduction and increasing liquidity of exchange-traded funds (ETFs) and narrow-based futures, trading various sectors has never been easier.
On May 5th I highlighted a few interesting sectors based on how traders were shifting their money between the Rydex mutual funds. At the time, I thought it looked as though Oil Services (OSX) and Consumer Products (CMR) were “over-owned” and may have difficulty on the upside, while Retail (RLX) and Banks (BKX) were being shunned by these traders and would likely be better candidates from the long side. Since that time, the OSX is down 4% (but was down as much as 8%) and CMR is basically unchanged (was down 4%). On the other hand, RLX is up 4% (but was down as much as 5%) and BKX is up 1% (but was also down about 5%). I believe some kind of pairs, or spread, strategy based in part on these fund flows has the potential to be effective. For example, if one had shorted the Oil Services HOLDR (OIH) and gone long the Retail HOLDR (RTH), it would have paid off handsomely without having to worry too much about general market direction. This is NOT a recommendation to go out and try this bright and early on Monday morning. Spread trading carries its own unique risks, and should be studied thoroughly before risking capital.
This naturally brings up the question about what may be interesting currently. Once again, Consumer Products enters the picture as one of the Rydex traders’ favorites. The assets took a quick dip after the last commentary, but again came on strong and are closing in on the highest level in two years. While CMR is flirting with its recent highs (but is below them, point A on the chart below), assets in the fund are acting as though a breakout has already occurred (point B). For those interested in following the sector, XLY is a decent tracking stock.
On the other hand, investors don’t appear to be quite so enamored with leisure and entertainment companies. The chart below is that of the Rydex Leisure fund, which contains stocks such as Walt Disney, Time Warner, McDonalds, Carnival Cruise Lines, etc.
Even though many of these leisure stocks have rallied 5%-10% in the past few weeks (point A), assets in the Leisure fund have actually dropped by nearly half (point B). On an absolute basis, assets are not at a point that I would consider extremely low historically, but I do find it interesting given the performance in many of the underlying shares over the past couple of weeks. I would also note the behavior of traders in December 2003 and January 2004. You can see on the chart that although leisure shares marched higher during that time, assets in the Leisure fund stayed steady or even declined a bit. That lead to further gains until money flowed into the fund and we saw something of a blow-off top in April.
One other fund that is displaying an unusual divergence is the Rydex Basic Materials fund, shown below. This fund concentrates on industrial equities such as Dupont, Dow Chemical, International Paper, Alcoa, etc.
Once again, we see traders avoiding this fund (point B) even though many of the underlying stocks have performed extremely well in the rally off the May lows, with many of them staging 5%+ comebacks (point A). Here, too, we can point to October 2003, when these industrial equities generally advanced well, but assets in the Basic Materials fund languished. That lack of buy-in from Rydex traders was a signal that there was some disbelief in the rally, and that steadfast pessimism in the face of rising prices fueled yet more gains. XLB is a good tracking stock for this sector.
There are two ways to interpret the lack of trader participation in the Rydex fund rallies. Either it is a sign that there is inadequate demand to fuel further rises, or it is a sign that trader sentiment is extremely pessimistic and there is money on the sidelines that should allow for further price gains. I tend to subscribe to the latter camp, believing that Rydex traders in aggregate are very poor market timers, and serve as good contrary indicators. When they are gung-ho on a group, I get worried and when they don’t want to touch something with a ten-foot pole, I become interested on the long side. This is not because money pouring into or out of the Rydex funds necessarily impacts the prices of the underlying shares. To some degree it does, but the amounts we’re talking about here are so miniscule compared to the average daily volume of most of the stocks that the Rydex managers don’t exert undue influence. The reason this type of analysis tends to work consistently is that Rydex traders are a microcosm of a broader population of investors, and by watching this sample, it gives us a good idea of the sentiment of the masses.
Conclusion
The low implied volatility readings are troubling on some level, as we have become accustomed to high-volatility situations. While I have shown before how the market tends to under-perform after low-volatility periods compared to high-volatility ones, I have to keep reminding myself that in the three years from 1993 through 1995, the VXO averaged 12.9, and spent 74% of its days below 13.8, which is where it closed on Thursday. This is while the S&P advanced 41% over that time.
The sentiment surveys showed a modestly large jump in bullishness in the latest go-round, though the bullish opinions are all well below where they were in January and all but one are below where they were in March. Still, our AIM model is back below 40%, which historically has been an overbought level that coincided with future market weakness. It must be noted, of course, that this warning sign failed miserably last year, as the S&P tacked on another 24% after the model first dipped below 40% in May.
Overall, I don’t see any reason to adjust the long-term view – May saw an important intermediate-term low, declines that put us into an oversold situation should be viewed as opportunities to add or initiate long exposure, we should see modest gains for the year, but the best strategy will most likely take advantage of oscillating indicators (selling overbought conditions and buying oversold ones) rather than breakout strategies. We are holding the modest long exposure in the model portfolio that we initiated at just under 109 in SPY, but will likely trim that if we see more of a rally.
Short-term, our indicator score is exactly neutral (telling us that most of the indicators are as well) as is our shortest-term model, STEM.MR. The STEM model, however, which is a little longer-term and has done a good job since last June, is now back below its lower trading band. Since June of last year, anytime the model has been above 40% (oversold), the S&P returned an average of 1.0% five days later, with 70% of the instances being positive. When it was below 25% (overbought), however, the average return dropped to -0.4% with only 36% of the occurrences being positive. That suggests that there will be a better time to be aggressive on the long side than now. For the moment, the sidelines seem to be the best place to be, but it should set up a decent opportunity soon – long if we see more of a decline, and short if we pop back up near the March/April highs.
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.