Rydex Traders Abandoning Tech

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June 13, 2006

9:00 PM EST

Rydex Traders Have Abandoned Technology,

Now Less Than 10% of Total Assets

Something we've been able to rely on lately is stories related to the death of "big tech". Usually they harp on the idea that Microsoft is a bloated behemoth with no original ideas, or that Dell is past its prime in a commoditized business.

Lots of investors have taken those issues to heart, apparently.

As of yesterday, only 11% of the components of the Nasdaq 100 were trading above their 50-day moving average, the lowest amount in nearly two years (click here for the sector breadth chart). This kind of "give-up" among traders is rare on this kind of scale.

Over the past decade - including the teeth of one of the worst bear markets in history - there have been a total of 36 other days that could claim the dubious honor of having these few issues trading above that average.

One month later, the Nasdaq 100 was higher after 31 of those days (86% of the time) by an average of +13.7%. The average maximum drawdown (i.e. worst losing period) was -5.8% compared to an average maximum gain of +19.0% - nearly four times as large.

Certainly this kind of performance wears on investors' attitudes, and that's evident when we look at where the assets are flowing in the Rydex mutual fund family.

If we combine all of the assets sitting in the OTC, Technology, Telecommunications, Electronics and Internet funds that Rydex offers, we see that they make up 9.6% of the total assets under Rydex's management.

The chart below highlights other times the percentage has reached this level.

One month later, the NDX was positive 98% of the time (45 out of 46 days) by an average of +9.5%. Drawdown was either minimal or nonexistent as tech shares took off soon after investors had become this apathetic.

One could make the argument that the introduction of so many exchange-traded funds and other investment vehicles has made some of these Rydex funds redundant, and it's a valid point. There is a possibility that we'll continue to see these fund assets dwindle as traders migrate toward the freedom of freely trading (and shorting) the ETFs.

There's no way to tell ahead of time whether or not this will be the case - we'll just have to watch and if tech doesn't bounce very soon, then that'll be one indication that watching the Rydex data this way could be "broken".

No Fidelity Sectors Have Outperformed Cash,

Typically a Sign That It Can't Get Much Worse

Of course, it isn't just tech that's getting sold.

More than any other period in a long while, it seems like almost everything is dropping in unison. These times of increased correlation among asset classes, market caps, valuation tranches and emerging vs. developed markets typically coincide with a panic move out of anything that might have "risk" as part of the equation.

There are an innumerable number of ways to look at that, but I thought one of the most telling was the Fidelity Select funds. I wrote about these funds on May 11th, describing at the time that the "best" stocks in a wide variety of sectors were diverging badly with new highs in the broader market, something that was often an ominous sign going forward. The pioneering work done in watching these funds in this way was done by Walter Deemer.

With the weakness in equities we've seen (and the rising yields on short-term "risk-free" paper), the number of these sector funds that have outperformed cash has dwindled significantly. In fact, they've dwindled so much that not one of the funds has shown a performance over the past quarter that exceeded the return on 3-month Treasury Bills.

That's ugly, for sure, but the potential silver lining is that it is so bad it can't get any worse (we'll never see fewer than zero funds do this poorly!).

That doesn't mean the market can't fall, but historically it has usually meant just that. The chart below shows the past five years of this indicator, and we can see that the last few times it has hit 0%, the S&P 500 bottomed almost immediately thereafter - and it paid handsomely to go along for the ride, at least for awhile.

Over the past 20 years of available history, whenever no funds were beating a cash return, it tended to mark a time when markets hit bottom (or close to it) and investors began moving back into high-beta sectors. For example, over the next quarter, the NDX showed a positive return 88% of the time with an average return of +15.6%. The average maximum drawdown was -6.4% compared to an average maximum gain of +20.5%.

It seems like we're too early in the decline to see this kind of extreme, but I don't want to second-guess the data too much. There can be a tendency for us to find fault in every indicator we study, and while it pays to be aware of their limitations, sometimes it's just best to take things at face value.

Should See Tradeable Low Within a Week, But

Still Think a Tough Summer is Ahead

In the intraday notes this morning, I mentioned that the first sentiment survey to be released this week, from lowrisk.com, showed another high percentage of bearish respondents. Over the past four weeks, the bull ratio in the survey (bulls / (bulls + bears)) has averaged only 32%.

That 32% figure is extremely low historically, and while the survey's history doesn't even go back 10 years, it has been as reliable a contrary indicator as any of them. Three months after previous forays into comparable depths of pessimism, the S&P was positive 90% of the time by an average of +6.5%.

We're also getting some unique readings from several of our "smart money" gauges. When looking at how many call options that OEX traders have that are currently outstanding, we see that the number is the highest in nearly 8 years.

Call options are only one side of the equation, of course - we also need to look at how many puts are open. And when we do that, we see that they are not anywhere near the type of extreme that calls are, a mild suggestion that these traders generally expect rising prices going forward.

I don't want to read too much into this particular indicator, however. We're approaching expiration, so this will look vastly different a week from now. Also, we're still seeing the remnants from a single trade that was put on last month that is skewing these figures somewhat.

As of today's close, the spread between our Smart Money Confidence and Dumb Money Confidence has widened to +38%. This is now at a level that deserves our attention. While it got more extreme in 2001 and 2002, when it gets to this kind of spread we generally want to be shifting our focus to finding the opportune time to put any extra cash to work, instead of looking for places to sell.

I've noted in the intraday notes a few times that it seems like there's an "issue" out there - a string of hedge fund collapses based off the newfound correlation among different asset classes perhaps - and the brokers being down almost another 5% today alone is an intriguing sign pointing in that direction (if a hedge fund fails, their brokers can often suffer direct losses, or they can be in the crosshairs of angry investors and red-faced regulators). If we would happen to see that kind of thing come across in the coming days, I'm confident it would mark the low or very close to it.

Barring a major fund collapse or other extraordinary headline, I'm not yet interested in buying into new lows. I would like to see some kind of interest from buyers before trying the long side for a multi-day or multi-week trade, and as such I'm looking for the S&P and NDX to recover today's highs before I'm willing dip my toe in the water on the long side for a swing trade. Things could change quickly in this environment, though, and I will be sure to note any developments in the intraday notes.

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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