08/27/2010

(This is an excerpt from Friday's blog for Decision Point subscribers.)

The basic Rydex Ratio is the result of dividing Rydex bear funds by Rydex bull funds, and we can use it to gage market sentiment. I think it is useful because it is based on the deployment of real money, not just opinions. 

I haven't mentioned the Rydex Ratios much in the last several years because Rydex mutual funds began losing assets after an historical high at the end of 2004, and I began to wonder if the Ratio concept would survive a continuously diminishing asset base. On the chart below we can see how Rydex total assets began a down trend in 2005 that lasted until the end of 2008. Most of that decline took place while the stock market was in a rising trend.

The reason for this decline in assets, I believe, was due to a huge increase in ETFs, which drained assets away from traditional mutual funds. Rydex was particularly vulnerable because these funds were set up to attract active traders, and ETFs were (and are) superior products in that they trade like stocks and ETF positions can be opened and closed at any time during the trading day. 

I recently noticed that assets have been flowing back into the Rydex group since the 2009 low, so I took a look at what was going on with Rydex cash flows. (Note that cumulative cash flow differs from total assets in that it shows total dollars flowing in/out of a fund, not simply the current value of fund assets.) The chart below shows that money has indeed been moving into bear funds durning the rally that began in 2009; whereas, flow into bull funds has been tentative -- making new highs, then dropping back to the 2007/2008 base. Incredibly, there was virtually no outflow from bull funds during the 2007/2008 bear market. Note that the bull fund outflow from the April top took the Bull+Sector index to a low not seen since the 2000/2002 bear market.

Looking at the raw readings we can detect the tentative nature of the bulls that has plagued this bull market, and it is obvious that the bears have been progressively more aggressive. Next we need to do the Ratio calculation.

The Ratio helps us identify points at which bullish or bearish sentiment have reached extremes that could result in price reversals. When we look at the Rydex Cash Flow Ratio below, we can see a trading range that has persisted since 2003. There are only two instances where the top of the range has been reached, and each resulted in a correction the most recent being the most severe. The bottom of the range was encountered numerous times, and each time there was a rally. Most notable is that the recent rally has so far been one of the smallest.

I have also marked the bottom of a smaller trading range that formed during the recent bull market. The Ratio blew through the bottom of that range during the current correction, and the most recent Ratio top suggests that it could prove to be a new benchmark for overbought.

Bottom Line: Upon closer inspection, I believe that the proliferation of ETFs has not adversely affected the usefulness of the Rydex Ratios. The most difficult problem to solve when using them is to provide a context within which to identify levels where sentiment is too extreme in one direction or the other. The range of the last seven years looks like something we could rely upon in the future; however, we also need to be alert for the formation of more narrow ranges that may be useful during shorter time frames. For now I think there is the potential for a Ratio range between the July low and the August top. I will be looking for price tops at the top of that range, and for rallies at the bottom.

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Technical analysis is a windsock, not a crystal ball. 

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BIO: Carl Swenlin is a self-taught technical analyst, who has been involved in market analysis since 1981. A pioneer in the creation of online technical resources, he is president and founder of DecisionPoint.com, a premier technical analysis website specializing in stock market indicators, charting, and focused research reports. Mr. Swenlin is a Member of the Market Technicians Association. 

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