Reversal Should be Authentic

Bottom Line: Rydex traders have abandoned the banking funds that that firm offers, to an extent that has lead to longer-term rallies every time we have seen it.

I often write about the behavior of traders who use the Rydex funds, as they have been a consistently useful repository of contrary investment ideas. When they have become overly enamored of a sector or the market in general, we often see weakness going forward, and vice versa. Now, it appears as though we are seeing a general loathing from the group towards banking stocks, something that over the past five years has resulted in future gains 100% of the time.

As of yesterday, combined assets in the Rydex Banking Fund and the Rydex Financial Services Fund totaled $41.2 million, the lowest amount since May 17^th, and one of the lower totals since 2000. While today’s pop in the group will almost assuredly bring in some money, the fact that assets have gotten this low in the first place has been a longer-term positive in the past. The table below shows the future performance in the BKX the given number of days after assets have become so low since 2000.

BKX Performance After Rydex Banking “Give-up” 2000 - 2004
	10 Days Later	30 Days Later	60 Days Later	90 Days Later	120 Days Later	250 Days Later
Avg Ret	4.4%	6.9%	12.3%	17.0%	21.0%	33.3%
% Pos	73%	80%	79%	99%	100%	100%
Max	25.0%	27.1%	36.3%	32.7%	37.2%	51.5%
Min	-5.4%	-9.1%	-8.0%	-1.5%	4.0%	7.8%

What we can see from the table is that compared to the potential reward after total assets became so low in the past, the risk associated with the group now appears small. The maximum gain across all time frames was about triple the maximum loss, and when we look out six months to a year, every instance (encompassing 77 days) was positive. The chart below plots the combined asset levels, with arrows denoting those times assets became as low as they were yesterday.

The dramatic decrease in assets in the funds that we have seen over the past few weeks, to this low of a level, has really only been seen in July and October 2002, and May 2004 over the past couple of years. The interesting thing is that so far, we have seen the smallest retracement out of any of the instances when assets flowed out to such an extreme previously. In fact, we would have to go back to May and September of 2000 to see the only other times assets in the funds have decreased by at least 50% with such a small decrease in banking shares themselves.

Certainly Rydex traders are pulling money out of the group to support the view that bank stocks have topped out, but their history of correctly calling turning points is suspect at best. Looking at the data above, it looks like if one has a long time frame, waiting for Rydexers to give up on the sector has been an opportune time to become positive on these shares. And I think it’s a relatively safe bet to suggest that they have lately given up indeed.

Bottom Line: The pattern we have seen in the S&P 500 over the past three days is rare, and while the sample size is small, its precedents have lead to a higher market with consistency after 30 days.

We have seen an interesting pattern form in the S&P 500 over the past few days, something which is normally associated with a short- to intermediate-term reversal. Below I have outlined the criteria for the pattern:

These points have not been optimized at all – they are simply generalizations which reflect our current environment. Looking at the S&P since 1962, it becomes readily apparent that this type of pattern is extremely unusual, having occurred only 10 times in those 40+ years. Even though it is so unusual, we were lucky enough to experience this very thing – twice in rapid succession – in August, as the chart below shows.

The pattern did indeed fulfill its promise as leading to a reversal. While the S&P’s performance over the short-term following these patterns was neither more nor less than random, what we did see is that 30 days later, the market was higher 9 out of 10 times with an average return of over 3%. After 90 days, it was higher 6 out of 8 times with an average return of just under 7% (there are only 8 instances here because 90 days have not yet elapsed since the two occurrences in August).

The market constantly cycles through periods of heavy buying and selling pressure, and periods of indecision. We have seen all three of those in the past three days, and the pattern is not only pleasing to the eye, history suggests it should be pleasing to the bulls as well.

We continue to see a variety of mixed extremes in many of our measures. The lowrisk.com sentiment survey I discussed a week ago is showing extreme pessimism, yet Investor’s Intelligence and Market Vane are showing extreme optimism. Odd lot short sales yesterday were the highest since August 6^th, a sign of extreme pessimism, yet put/call ratios have been very low over the past few days, a sign of optimism. The VIX has been spiking a bit (getting stretched more than 10% above its 10-day average), a mild sign of pessimism, yet Rydex traders continue to put money to work in the bull-oriented index funds, a sign of optimism.

When we see these types of opposites, normally I expect a trading range environment and I do not trust breakouts or breakdowns from obvious technical inflection points. We have seen some excellent examples of that lately – the S&P losing the 1100 level, only to pop right back above it, and the Dow “decisively” breaking its August low, which it has now regained. I expect this type of action to continue for the time being, so if price moves back towards the lows formed over the past few days, it should become a good opportunity to add to long positions, while a move to the upper end of the range may stop advances at least temporarily.

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.