Risk is Now Significantly Higher
Wednesday, November 3rd, 2004 8:20pm EST
Chasing Beta the Rydex Way
Bottom Line: Our Rydex Beta Chase Index shows that those traders have been more than 20 times more likely to trade high-risk funds than low-risk funds, a sign of speculation that has been a decent precursor to short-term market highs.
Over the past couple of days, I have mentioned our Rydex Beta Chase Index in a portfolio change and intraday comment. I don’t want to belabor the point, but since I mentioned a couple of things I was watching for in the last regular comment, I want to touch on it again tonight.
One of the things I noted was that while the level of assets in the money market at Rydex (relative to total index assets) was very low and that had quite bearish implications in the past, we still were not seeing any spikes higher in the Beta Chase Index or Enthusiasm Index, something that would have alerted us to not only complacency among these traders, but also excessive outright speculation on higher prices.
The activity over the past few days has changed that, as both indicators spiked into extreme territory. The Beta Chase Index, in fact, has not only spiked higher, it has recorded new all-time record readings over the past two days. Yesterday’s reading of 23 basically tells us that these traders have been 23 times more likely to invest in a high-beta (or “risky”) fund than a low-beta (or “safe”) fund. Such an overwhelming willingness to take on risk has been approached only two other times in the history of the indicator – March 21, 2003 and June 30, 2004. Both instances marked short-term tops in the broader market as the S&P 500 went on to lose several percent over the next week.
Last time, I showed a chart of assets in the money market at Rydex, and highlighted other instances of them being as low as we had been seeing lately. Below, I have included the Beta Chase Index on the chart, with the red dots spotlighting those times when not only were money market assets very low, but speculation in high-beta funds was high. I think including the two together really shows the attitude of these traders – not only are they shunning the ultra-safe money market, but their preference is extremely high for the riskiest funds that Rydex offers.
Looking at other times over the past few years that the Beta Chase Index spiked over 10, we see that the S&P was able to muster a maximum gain (on a closing basis) of an average of 0.6% over the next 5 trading days. Conversely, the maximum loss over the next week was an average of 1.9%. Over the next 10 days it was able to rally 2% or more five times, but it fell more than 2% ten times. This shows that when we look at the risk/reward of taking a long position here, the risk seems to outweigh the reward after times Rydex traders have become very speculative in nature.
I have written about assets in the various Rydex funds extensively over the past couple of weeks, and I don’t want to get to the point where that’s the sole focus. It is certainly not intentional, but I do find great value in how these traders deploy their capital. We’re not looking at someone’s opinion and trying to guess whether they have acted on their beliefs or not, we are seeing in near real-time how they are allocating their money. Watching this money flow has tipped us of to some great opportunities over the past couple of years, and it should continue to do so. Recent activity in these funds suggests the market should decline in the short-term to shake out some of this excessive speculative behavior.
Odd Lot Love
Bottom Line: Traders who buy shares at clip of fewer than 100 shares at a time have been as aggressive over the past week as at any other time this year. Their track record shows that such optimism is not a good sign for bulls.
Not only are Rydex traders apparently “feeling the love”, we also see other traders who tend to be wrong at the extremes positioning themselves for more of a rally. Put/call ratios have been quite low for the past week, and the 5- and 10-day moving averages are approaching levels last seen at some of the prior peaks this year. Instead of showing the put/call charts, however, I want to highlight odd lot purchases.
Recall that an odd lot is a trade for fewer than 100 shares. While there may be some manipulation of the system by professional traders using odd lots to get around regulatory burdens, we continue to see odd lot activity as being a good contrary indicator at the extremes. Yesterday, purchases made in odd lots hit 16.9 million shares, one of the highest readings so far this year, and the most since June. Over the past five days, these purchases have averaged more than 13.5 million shares, which is the second-highest reading so far this year.
The chart below shows the 5-day average of these purchases, with the red dots highlighting those times they spiked to a similar degree to now.
Such aggressive buying by these traders coincided with the market peaks in early March and late June and far surpasses anything we have seen since the June occurrence. Odd lot data has been fairly effective this year at pinpointing when small, wrong-way traders have been feeling excessively bullish or bearish, which coincidentally pinpointed many of the turning points in the market. Once again, these traders have positioned themselves to profit from a market rise, and their track record tells us to be wary because of it.
Conclusion
One of the other signs I mentioned I would be watching for last time was another day when OEX call open interest declined from the previous day. As I said then, it is very rare to see open interest in those options decline (outside of an expiration), and generally when we see OEX traders actually close out call positions on net it has lead to market weakness going forward. The very next day, last Friday, call open interest did indeed fall once more. This is the first time since mid-August 2002 that we have seen back-to-back days with declining OEX call open interest that was not immediately influenced by an expiration.
We have seen the signs I mentioned that would lead me to believe the risk/reward was moving increasingly away from longs, and so we sold out of the model portfolio long position early yesterday afternoon and will wait on the sidelines until something better comes up. I don’t think it makes sense to be adding long positions right now given the data presented above, but I also respect the evidence we saw in mid-October which lead to the portfolio’s long position in the first place. The market action we have seen since then has been absolutely classic in defining a low, and I continue to feel quite positive about the longer-term prospects (out a few months). But over the coming weeks, I do think there is significant risk in holding long positions, so until we see these speculative signs abate we will watch from the sidelines.
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.
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