Friday, August 25, 2006

Rydex Funds: A Different Measure of Market Psychology

In my recent post, I emphasized that markets--like individual traders--have their own psychology. That psychology, captured in the put/call ratio and the amount of funds being devoted to options, turned out to be important to near-term returns.

The excellent Decision Point site tracks the cash flow in and out of the various Rydex funds. It turns out that this provides a very worthwhile intermediate-term picture of the market. The chart above, from the site, looks at funds in the bull and sector funds (top panel), bear funds (middle panel), and total bull, bear, and money market funds (bottom panel).

Several patterns to notice:

Bear market funds tend to expand and peak around intermediate-term market bottoms. That occurred in May and August of 2004 and in April and October of 2005. Most recently, we've seen a spike in bear market funds in June, 2006, with the market's decline.

Observe how, even with the recent market rise, bear market funds remain elevated at present. Rydex traders are treating the current market more like a market bottom than top--an indication of market psychology that is worth keeping in mind.

A second pattern that shows up in the data is that bull and sector funds tend to peak ahead of the S&P 500 Index. They peaked in late December, 2004; late July, 2005; and December, 2005. The bull funds also tend to be at relative low points when the bear funds peak, suggesting that traders are pulling money from bull funds to short the market--and are tending to do that at market bottoms.

Notice how the current market is at a relatively low level of bull funds. Once again, Rydex traders are treating the current period quite bearishly.

Finally, notice total Rydex fund assets. We grew those into late 2004, but since 2005 we have not seen an addition to those assets as the market has moved higher. Because bull funds dominate the Rydex assets, we see that total assets also tend to lead relative market peaks. So far, funds have remained well below recent peaks.

During the market's most recent rise, we've seen an expansion of bull assets and a decline in bear assets--as would be expected. Interestingly, total Rydex assets have dropped during this period, as traders have pulled holdings from money market funds. Rydex traders have been pretty good contrary indicators of market psychology over the past two years and, right now, they're hardly acting bullish.