Rydex Traders Giving More Reason For Worry

03/27/09 9:00 AM EST

Good Friday morning...We begin the day with some selling pressure in the pre-market futures, with the major indices off about 1%.  The morning's economic data was mostly in-line with expectations, but overseas markets and the early news flow has been blah.

A few days ago, we touched on the asset flows into a couple of Rydex tech-related funds.  In the past, such aggressive moves into any sector funds by these traders would normally touch off a short- to intermediate-term counter-reaction, but so far tech is hanging strong.

That has not been lost on these folks, as they continue to flood the Internet and Electronics funds.  The Internet Fund now has $70 million in assets, near its all-time peak.  They put more money into this fund only in August-September 2000 and again on October 23, 2007.  I can't think of two worse times to try to invest alongside them.

In general, these guys and gals are reducing their short-side risk in droves.  Total assets in the four major inverse funds (that lose money as the market rises) have now dropped to very near a seven-year low.  It bounced around similar levels in mid-December and early January as the market was topping.

A plausible explanation for the drop in these assets may be that traders have fallen in love with a new way to bet against the market.  We certainly know that they aren't buying put options (put/call ratios are at their lowest levels of the bear market), so that's not it.  But maybe the inverse exchange-traded funds are the culprit.

Umm, not really:

Total volume in the six major Proshares inverse index ETFs is high, but down about 30% from the peak levels seen earlier this month, and is less than half what we witnessed last fall.  It's certainly not high enough to explain away the exodus from inverse funds at Rydex, or the lack of interest in put options.

This type of data has helped to move our Intermediate-term Indicator Score back to "uh-oh" levels, last seen in early January.

The Score only goes back to 1999, but during bear market conditions (a downward-sloping 200-day average on the S&P 500), when it has become this extreme the forward one-month return in the S&P has averaged -4.1% with only 14% of days (10 out of 69) sporting a positive return.  The maximum risk during those month-long trades (-6.7%) dwarfed the maximum reward (+1.9%).

Looking out three months, it was even worse - an average return of -7.2% with only 3% of days being positive and a much worse-looking risk versus reward (-13.7% versus +2.3%).

Bottom line - Intermediate-term

Nearing the end of the first week in March, we went over a number of indicators and studies suggesting that we were very likely within days of an inflection point.  Sentiment had reached an extreme (the setup) and the price pattern coincided almost perfectly with past lows (the trigger).

The market failed to follow through immediately on the upside, which was messy and somewhat unusual, but still basically within the confines of the risk parameters mentioned in the past studies.

After March 10th's "blast off" day, we needed to see some short-term follow-through, per the tables from Wednesday and Friday that week.  We unquestionably saw that, which basically means that it would be unprecedented to not see generally higher prices over the next one to three months.  Pretty much everything we've looked at since then helps confirm that.

Over the past couple of days, after the 20%+ rally we've seen, my outlook has been growing a little dimmer.  Instead of putting any kind of handicap on the upside, it has seemed more likely that we would be entering a multi-month trading range, with 875ish the likely upper end of that.  As we near that general area, with the readings we're seeing as noted above, it makes sense to expect the risk/reward to tilt more towards the "risk" and less towards the "reward" on long positions for now.

Bottom line - Short-term

The market put in about as good a performance as can be asked yesterday - a higher open, never traded negative on the day, with a higher high than yesterday, and a higher close than both yesterday's close and today's open.

We've looked at these kinds of one-sided days several times in the past, but most of the time it has been on the downside.  These one-sided upside days have not been especially kind to late buyers during this bear market, with the next day showing a positive return only 35% of the time with an average return of -1.0%.  13 of the last 15 have been negative the next day, with a maximum risk more than twice as great as the maximum reward (-2.5% versus +1.0%).

Combined with some of the other negatives, such as the 10-day Up Issues Ratio, the Equity Put/Call Ratio and Rydex traders, it does seem as though the upside should be fairly limited and further gains likely only temporary.

Many are pointing to end-of-month seasonality, which should be a positive for stocks here.  However, since the inception of the S&P 500 futures, the index has shown a positive return during the last three days of March only 38% of the time, averaging a return of -0.6%.  If the month was up more than 5% heading into the last few days, then the last three days of March were up only 1 time out of 5 attempts (and that one successful instance gave back all its gains and then some during the first few days of April).  I wouldn't count on seasonality being a bullish factor until we're in April.

The wild card could be performance anxiety - the feeling among fund managers that they need to press their bets on the long side for these last few days in order to make up for poor performance during January and February.  That's certainly possible, but in all the attempts I've made to quantify it, not something I can point to here as a likely positive.

Looking back at the S&P since 1928, I could find five times the S&P was down 10% or more during the past quarter, then rallied 5% or more in the month leading up to the last few days of a quarter-end.  Those last three days were positive 2 times, negative 3 times with an average return of -1.8%.

The intraday version of our most sensitive indicators hit oversold levels late Wednesday afternoon, and the markets responded extremely well, something we haven't seen for awhile.  That's a healthy longer-term sign, but for now they're mostly back to neutral and not a supporting factor.  Given everything else we've looked at, I expect some backing-and-filling heading into early April, and won't expect any further gains from here to be sustained.

Given

All the best,