Rydex Traders vs. ETF Traders

Bottom Line: Traders who favor the Rydex mutual fund family have not embraced this rally as they have the others this year. From a contrary perspective, that is a bullish phenomenon.

One of the more consistent ways we can monitor when investors become excessively optimistic or pessimistic is through watching the real-money asset flows among the various Rydex mutual funds. This data can be very useful mainly because of the leveraged funds available at that fund family, a type of speculative vehicle that tends to attract those investors most married to their opinions. The monitoring of such activity in mid-August, when leveraged bear assets reached an all-time high, was helpful in determining that we could be close to another low.

Now we have another interesting situation with the Rydex funds. Since the rally off the August lows, these traders have not jumped on the bandwagon like they have previously. Normally after a 5% runup in the S&P, we would see our Beta Chase Index spike higher (showing a preference for riskier funds), but that index remains muted. Or our Enthusiasm Index would hit a high level, telling us that traders were betting on the upside to a greater degree than is warranted by the underlying price action – we haven’t seen that either. But perhaps most telling is just the absolute amount of dollars in the leveraged bull and bear funds themselves.

The table below shows each rally of 5% or more this year in the S&P 500, along with the changes in the total amount of money invested in the leveraged bull funds and the leveraged bear funds.

Dates of Bottom to Top	% Rally in S&P	Change in Bull Funds	Change in Bear Funds
3/24 – 4/05	5.4%	+21%	-24%
5/17 – 6/30	5.2%	+16%	-27%
8/12 – 9/10	5.7%	+6%	-18%

We can see that the current rally is similar to the other two in terms of time and price. But look at the changes in the Rydex funds. In the previous two rallies, the bull funds enjoyed a nearly 19% gain in total assets, while the bear funds saw their assets deflate by around 26%. During the current rally, however, bull funds have attracted only an additional 6% in assets while bear funds have only decreased by 18%, both well below the previous two instances.

If we look at the assets at each of the previous market peaks so far this year, another development stands out. The chart below shows each of the market peaks as well as the total bull and bear fund assets. The table below will explain the movements a bit more.

The table below shows the difference in the S&P at each of the peaks and also the changes in the bull and bear funds.

Dates of Peak to Peak	% Change in S&P	Change in Bull Funds	Change in Bear Funds
3/5 – 4/5 (A to B)	-0.5%	-1%	+15%
4/5 – 6/30 (B to C)	-0.8%	-3%	+5%
6/30 – 9/10 (C to D)	-1.5%	-17%	+19%

From the March to April peaks in the S&P (from point A to point B on the chart), the S&P was 0.5% lower at the April peak than the March peak. At the same time, the bull funds were about 1% below where they were in April than in March, while the bear funds were 15% higher.

From the April to June market peaks (B to C on the chart), the S&P was 0.8% lower in June than in April. The bull funds peaked out about 3% lower in June than in April while the bear funds were about 5% higher at the second peak.

Now at our current juncture, the S&P is about 1.5% lower than that the previous peak in June. But the bull funds are 17% lower now than they were then, while the bear funds have 19% more assets now than they did then. This is a significant display of a lack of “buy in” among Rydex traders, as they are not moving assets out of the leveraged bear funds and are also not moving money into the bull funds. When considered in addition to the first table, we can see that Rydex traders are not only not excessively optimistic about the future, they are considerably more hesitant to trust this move up than they were previous rallies this year. From a contrarian point of view, which I think we must take with these traders, this is a positive sign and suggests the market has further to roam on the upside before rolling over again. If we see these traders shift gears via a spike in the Beta Chase or Enthusiasm indexes, that would be a definite caution sign.

Bottom Line: Contrary to the Rydex traders above, traders who favor exchange-traded funds are trading them less aggressively than the underlying component shares to a degree that has coincided with market weakness a great majority of time this year.

The Rydex data above shows us that those traders in particular are not chasing this rally, which could be considered a sign of uncertainty or fear as it’s commonly called. There are a few measures out there, however, that follow a different population of traders and that are giving conflicting signals. The implied volatility measures (VIX, VXO, VXN) that I’ve touched on a few times recently are scraping along at multi-year lows, which means that traders are not pricing in the prospects of a volatile September. This is unusual in a few respects, and I do consider it a minor negative.

One other way to determine how “uncertain” traders are is by watching the volume in the index exchange-traded funds (ETFs) such as the S&P 500 tracking stock, SPY, and its Nasdaq 100 counterpart, QQQ. When we compare the volume in these ETFs to the volume in their underlying components, we can see whether traders are giving any importance to the ease of trading (and selling short) and liquidity of the ETFs versus the underlying stocks. When they are fearful of a decline, traders tend to avoid trading individual equities and instead concentrate on the exchange-traded funds. Vice-versa for when they are confident of continually rising prices.

Over the past few days, trader behavior has shifted dramatically from what we saw a few weeks ago. For example, on August 6^th, the Liquidity Premium for SPY was 73%, meaning that the relative volume in SPY was 73% higher than it was in the 500 underlying components of the index. The S&P did not close materially below that level over the next few days as it was finding its low. Over the five trading days from August 6^th through August 12^th, the Premium averaged +29%.

Contrast that to what we are seeing now – on Friday, the Premium closed at minus 42%, the lowest number since June 18^th. Over the past five trading days, the Premium has averaged a measly -24%, which is the lowest since June 29^th (the day before the market peaked). The 10-day average of the Premium, which is what is posted to the site (click here for the Chart Quick Pick feature, then scroll down to the BREADTH section, then click on SPY Liquidity Premium) is still not extremely low, though. It would take about 3 more days of traders avoiding the ETF in order to push it to around some of the lowest levels seen yet this year.

Let’s take a look at any day this year when that day’s Premium was at -30% or lower.

From the chart, we can see that there was a cluster of very low readings near the June peak, and generally, low Premiums coincided with future market weakness. In fact, 10 days after a daily Premium reading of -30% or lower, the S&P 500 showed a negative return 13 out of 15 times, with an average return of -1.3%. It was extremely difficult for the broader market to sustain any type of significant upside after traders displayed such confidence in their positions.

The Liquidity Premium for the QQQ is not nearly as low as it is for SPY, however it also did not reach the high levels of uncertainty we saw at the August lows that we did at the prior lows in March and May, making that one more difficult to read. The SPY Liquidity Premium has a good track record at calling market extremes over the past couple of years, and it has been very helpful so far in 2004, so these current low levels are of course troubling. If we do happen to get a few more days where traders favor individual equities greatly over the ETFs, I think the argument for an imminent top becomes more compelling.

The week after Labor Day was positive. According to the stats in the last comment, historically there has been a 50/50 chance the rest of the month will also be positive, and an 82% chance the rest of the year will be positive. As I said before, I don’t put a lot of credence in the “rest of year” figures based on the performance of one week, but the “rest of month” data is likely valid. A 50/50 chance for higher prices is nothing special, but it certainly beats the 27% chance had the week ended on a negative note.

We have several pieces of conflicting data as noted above. We see some groups of traders fighting (or at least not wholeheartedly embracing) the rally, such as is evident in the Rydex data and put/call ratios. But then we also see that traders are not pricing in the probability that this September will follow the weak seasonality that most others do, which is evident in the implied volatility measures and the SPY Liquidity Premium. How do we resolve these conflicts? I think that as long as price continues to act as well as it has, not giving any kind of substantial retracement, the uptrend should be followed, but with an extremely close eye. Existing long positions should have stops snugged tightly underneath, to keep taking advantage of rising prices should they come but getting one out once traders begin to suspect this September may end up like every other one over the past 5 years.

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.