Speculation Still Rampant
Tuesday, November 9th, 2004 7:30pm EST
Buy Japan, Sell Europe?
Bottom Line: Not quite yet. The behavior of traders in the Rydex funds leads to very consistent performance in a pairs trade between the two, but only when assets in the Japan Fund become higher than they “should” be.
Over the past couple of months, I’ve discussed Rydex trader behavior in banking and transportation stocks, both of which were very good clues as to a general malaise in sentiment which lead to good gains for both groups. I’ve been asked several times to comment on the Rydex Large Cap Japan Fund versus the Rydex Large Cap Europe Fund, two funds which have seen vastly different inflows over the past few weeks.
Part of the difference in the fund flows, of course, is due to the performance of the markets themselves. Since May 17th, the net asset value (NAV) of the Japan fund has risen 15%, while the Europe fund has risen 17%, so we could reasonably expect the Europe fund to attract a bit more in assets. However, since that date assets in the Japan fund have actually declined by 23% while assets in the Europe fund have exploded higher by more than 350%. While European large caps have broken to a new high, Japanese shares have not, so even though the percentage gains in the funds since May are similar, the new high in European shares is likely what has driven so much interest in the Rydex Large Cap Europe Fund.
I have talked before about how the $100 million mark in assets in some of these sector funds have tended to coincide with peaks in the markets themselves, and we see that with the Europe Fund as well – the last time the fund attracted close to $100 million was early this year, just as the market was peaking.
If investors are shunning Japan but piling into Europe, might there be an opportunity to create another pairs trade? This is something I have discussed before using Rydex data to sell short a sector that is “over-loved” and buy a sector that is “over-hated”. Such sector bets are becoming increasing practical, as futures and exchange-traded funds (ETFs) become ever-more accessible. Two ETFs available for these funds are IEV, which tracks European equities, and EWJ, which is tied to Japanese equities. Both ETFs track the Rydex fund NAVs very closely, though the liquidity and trading volume may be suspect at times.
As of yesterday, there was a little over $51 million invested in the Japan fund and $90 million in the Europe fund. Taking a simple ratio of Japan to Europe, we see that there was about $0.57 invested in Japan for every $1 invested in Europe. This is a relatively low amount, and suggests that traders could be too optimistic on Europe (or too pessimistic on Japan). At the other end of the spectrum, in the past we have seen this ratio as high as 11, meaning there was $11 invested in Japan for every $1 invested in Europe. Let’s see how the markets performed relative to each other at each extreme.
First, the chart below shows how Europe out- or under-performed Japan when assets in the Japan Fund were very high compared to assets in the Europe Fund. This would suggest traders were overly optimistic on Japan (or pessimistic on Europe).
Clearly there is an extremely strong bias here towards Europe doing better than Japan when the Japan Fund attracts 5 times as much in assets as does the Europe Fund. Looking out 60 to 90 days, Europe out-performed Japan by nearly ten percentage points, and the spread was tilted towards Europe more than 90% of the time.
Now, at the other extreme, when assets in the Japan fund were very low compared to assets in the Europe Fund:
Here the bias is not nearly as strong or consistent. In fact, even though Rydex trader sentiment towards Japan was very low relative to Europe, the Japan Fund still under-performed the Europe Fund a majority of the time up to 30 days later. After 60 and 90 days, we see a slight nod towards Japan in terms of average return, but this is not enough to base a trade on.
The current ratio of 0.57 of Japan to Europe assets is fairly low. However, as we can see from the chart above, it has been lower in the past and even then it did not mean anything particularly meaningful regarding future performance of the funds. It would be far better to concentrate on those times assets in the Japan Fund far outweigh – by a factor of 5 or more – the assets in the Europe Fund. If and when we see that in the future, it may be time to seriously look at a pairs trade involving going long IEV and short EWJ.
Closing Out Their Calls
Bottom Line: OEX traders have once again closed out more call contracts than they have opened, something which has pushed the Determination Index to a very high level.
Last time I mentioned an unusual occurrence that has historically had bearish overtones, and that was that open interest in OEX call options had declined from the day prior. We normally do not see declines in open interest unless it is immediately surrounding an expiration, as there is typically enough volume that new contracts are continually being created. Once again today, we see that open interest in these call options has declined, the third non-expiration-related instance since late October. This has pushed the OEX put/call open interest ratio up to 1.46, the highest since mid-June.
One of the ways I prefer to watch this data is via something I have discussed before, which I call the OEX Determination Index. Recall that this index is created by watching how much of any given day’s volume is used to open new put or call contracts. The more volume is used to open new put contracts as opposed to new call contracts, the higher the index will be. The chart below shows the index since the beginning of 2003, with the red arrows highlighting the other times the index has reached close to this level.
The index is currently sitting at 17%, which roughly means that traders have used 17% more of their put volume to open new contracts than they have used of their call volume to open new call contracts. Basically, it suggests that they are about as determined as they have been at any other time since the bull market began to have put option exposure. When we have seen them determined to this degree, the S&P has been lower after 5 days on 9 out of 13 occurrences, with an average return of nearly -1%. Obviously, since the market went on to new highs after every occurrence, this is strictly a shorter-term measure, but I believe it shows well the sentiment of traders who have a pretty good market-timing record.
Conclusion
Nearly everything I have pointed out in the past couple of comments suggests that the risk is high if attempting to establish new long positions. I could add to that by mentioning facts such as odd lot purchases last Thursday were the sixth-highest in the past 34 years, but I think the point has been made – we are seeing a very high level of speculation from traders who are mostly wrong on market direction when they reach this type of extreme.
Still, the broader market has done an excellent job since the October low, and from a longer-term perspective I continue to believe that oversold conditions should be used as opportunities to add to or establish long positions. However, even in solid uptrends, when we see the type of activity we have seen over the past week and a half, it leads to a correction a high percentage of the time. It’s difficult to find someone who doesn’t believe we are due for a rest, so I suppose that in itself suggests we are not going to get one, but getting away from anecdotal evidence, our measures suggest that too many people are leaning long. I continue to believe that it does not make sense from a risk/reward perspective to establish long positions with this type of sentiment situation, but I also do not wish to be short the market here. If we can decline and hold below the 1162ish level on the S&P, that would add a great deal to the idea that we will undergo a correction of a couple of percent (at least), but unless we see that, I am not willing to fight this uptrend.
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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