The Pending Stock Market Bottom Brought to You by Rydex ~ The Risk Averse Alert

Saturday, November 15, 2008

The Pending Stock Market Bottom Brought to You by Rydex

Carl Swenlin at DecisionPoint published an article yesterday titled, "Rydex Ratios Diverge." In this article Carl presented a few charts of "indicators that are useful in determining investor sentiment." These are "based on actual deployment of cash into Rydex mutual funds."

If you read the article, you will get a sense of Carl's view based on what these indicators are telling him.

Rather than offer a critique of his analysis — I'll only indicate my skepticism toward Carl's conclusion — let me instead make an observation using one of the charts he presents. This chart shows the net cash flow into Rydex mutual funds over the past three years ... segmented by bullish and bearish funds within the Rydex group.


As you are aware, the problem facing institutions with exposure to a widening swath of Structured Finance products has to do with their ability to raise capital. Recently, this problem has become so acute the U.S. Treasury has had to intervene with a $700 billion Emergency Economic Stabilization package.

Yet as you can see from cumulative net cash flows into Rydex mutual funds the need to raise capital predated the top in the stock market by nearly a year. From the second half of 2006 on ... both Rydex bull and bear funds have been getting drained.

What's probably most startling is the rate at which bear funds have been sold during the market's recent swoon. Normally, you would expect just the opposite! Case in point ... look at the first half of 2006. As the market weakened ... money flew into bear funds.

Here, then, is how I see the present period... When you're starved for capital you sell your most profitably-performing, in-demand holdings. Hence, the cash flow we see coming out of bear funds.

Now, look back to the mid-year, 2006 period...

See anything similar to present circumstances?

Bear funds were getting drained... Bull funds were growing... Hey, what do you know! Just like now.

And what was the market doing then?

That's right ... it was bottoming.

Case closed.

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Anonymous said...

Hey Tom,

Love your site and it has been a great resource during these times.

I have to say that I disagree with your conclusions that the market will bounce. Instead, I believe we are on the verge of another decline.

Of course it is always possible to find reasons to be bullish or bearish, but here is my case. Taking a step back, these are the recent major market movements (shown with SPY):

3/10: 128
5/16: 143
7/15: 121
8/29: 130
9/10: 88.5

I believe these dates and prices show how every rally has grown weaker in strength and duration, while each sell of has grown in intensity and duration.

I think we are on the verge of another steep sell off. We have just been in the midst of a failed rally, I think in the coming weeks or days, it will become a full borne sell off. I would short energy materials shippers miners China etc. The first rally was 2 months, then 1.5 months, and this would be about 1 month.

2 things are keeping me from committing 100% of my capital to the short side. The intensity and volume of the rally on Thursday was shocking, however I think the volume can be accounted for by the huge amount of orders near the 2008 lows. I view this rally like the 9/17-9/18 rally which in retrospect was an amazing short entry point. The poor follow through of the rally was severely punished in the final hour rather than the next day.

Another worrisome point is the diminishing volume on down days following the 10/9 "bottom", which indicates some exhaustion of selling at these levels, since I believe that we are in the midst of an attempted rally, I think this is more of an indication of lack of buying interest. I think the selling will resume once we decisively plunge below 2002 lows.

Hopefully my perspective is helpful. Any thoughts/comments would be appreciated.

TC said...

Thanks for your complement! I am delighted you found my analysis helpful.

It's going to be challenging over the next few years to keep an open mind. Seeing the forest for the trees is going to require some effort to realize that, all is not dead wood.

Now, per your extrapolating the market's major moves over the course of 2008 and concluded the trend suggests a crushing blow is up next, I completely understand your thinking. However, at the present moment my Elliott Wave analysis (substantiated by my read on underlying technical measures taken in historical context) has me strongly suspecting a bottom is at hand. As I have been stressing, this bottom probably will take some time to form.

The one thing I would ask per your extrapolation... When do selling bouts featuring increasing losses end in your estimation? Obviously, if there's no end in sight, then SPY eventually could go to zero!

As someone with a mind to be 100% short, I think you are wise to be concerned about Thursday's volume. As I indicated in Thursday's commentary, strong bidding coming in near '08 lows suggests bottom might not be much further below present levels.

Per Thursday's similarity to the 9/18-9/19 rally, there's something you're missing. I wrote about this, too, on Thursday. Preceding mid-September's rally volume was increasing as indexes sunk to nominal new '08 lows. In the present instance, however, just the opposite has been the case. Volume indeed shrank as indexes recently sank to nominal new lows. I believe this difference -- now versus September -- is significant.

I thought Friday's action was a reasonable consolidation of Thursday's bolt higher. This could last another day or three before indexes rise to the upper end of the past month's trading range. Again, this anticipated, near-term advance is within the context of the market's ongoing bottoming process. Subsequently, whether bottom comes with a decisive plunge below '02 lows remains to be seen. I have my doubts this will happen. I suspect the worst for the moment is over...

Now, per diminishing volume since the early-October "bottom," I agree with your general conclusion about it revealing both selling exhaustion, as well as a lack of buying interest. However, Thursday's turnaround goes some way to alter the seemingly inconclusive volume message since October 10th.

On November 10th I wrote about there being "no denying every effort is being made to forestall collapse." Then I tempered this observation by admitting there's little technical evidence indicating a consensus belief this effort will succeed. Well, Thursday's rally on notably wider volume provides evidence belief is starting to build. Still, I consider it a meager offering, relatively speaking.

That's why on November 10th I suggested looking back to the July - October 2002 period. The market was in the process of bottoming then. Yet, it was not until March '03 that a powerful advance got under way. So, the bottoming process took some months before it was complete. It seems reasonable, then, given circumstances leading to the present moment, some time will elapse before the charge higher I am anticipating enters stage left.