Wednesday, April 21, 2010

Rydex Market Timers: How Extreme?

This analysis will give you greater insight into one of the Rydex indicators that is published in the weekly report on investor sentiment. Specifically, we are going to look at the Rydex Total Bull v. Total Bear indicator.

The Rydex Total Bull v. Total Bear chart is a weekly chart constructed from the assets in all the bullish funds and the total amount of assets in all the bearish funds. When the indicator is green, Rydex investors are bearish and there are more assets in bearish oriented funds than bullish oriented funds; in general, this is bullish for higher prices. When the value of the indicator is above 58% (arbitrarily chosen) an intermediate term top is near. The Rydex Total Bull v. Total Bear chart is shown figure 1; the red dots over the price bars indicate when the indicator value is greater than 58%.

Figure 1. Rydex Total Bull v. Total Bear

As always, I will try to put some context to the observations we note on the chart, and to do this we need to construct a strategy. In this instance, we are going to short the S&P500 (symbol: $INX). Our entry signal is when the Rydex Total Bull v. Total Bear indicator is greater than 58%, and our exit signal to cover our short is when the indicator turns green, suggesting that the Rydex market timers have become too bearish (i.e., bull signal).

The first trade from this strategy was initiated on May, 2001. Out of the 11 total trades, 3 occurred prior to 2003 or in the bear market to start the decade; 6 trades occurred between 2004 and the 2007 top. So while the number of signals is limited, the trades are spread out across bull and bear markets. Interestingly, the largest individual trade drawdown (8.26%) occurred in the November, 2001 trade; in this instance, you would have been shorting in a bear market, so this is somewhat surprising.

This strategy generated 11 trades. There were 8 winners yielding 706 S&P500 points. The Maximum Adverse Excursion (MAE) graph is shown below. The MAE graph assesses each trade from the strategy and determines how much a trade had to lose in percentage terms before being closed out for a winner or loser. You put on a trade and if you are like most traders, the position will move against you. MAE measures how much you have to angst and squirm while you are in that position. As an example, look at the caret in the MAE graph with the blue box around it. This one trade lost 3.8% (x-axis) before being closed out for a 3.4% winner (y-axis). We know this was a winning trade because it is a green caret.

Figure 2. MAE Graph

Several things to draw from the MAE graph: 1) there were 3 trades with a draw down of greater than 5% and this is to the right of the blue line; 2) this may seem excessive but no trade lost more than 2%. So think about it for a second: The indicator moves above 58%; you go short; by the time the next bull signal arrives it is unlikely that you would have lost more than 2% of your equity, and it is very likely that you would have added to your equity (as 5 out of 11 trades had gains > 5%); there is a better probability of the trade turning out a winner.

Staying with our theme of how extreme "things" have gotten, the indicator in figure 1 first hit the 58% mark 7 weeks ago with the S&P500 at 1149.99. Since that time, the S&P500 is up a little less than 5%. This is still within the extremes of prior adverse moves as pertains to the strategy above. It is evidence such as this that suggests to me that the market is a better short than long. I have no reason to believe that the cycle of fear and greed is broken, and if this plays out as expected, the market should be trading lower by the time the next bull signal arrives.

Did you know TheTechnicalTake Blog offers Premium Content based upon the Rydex asset data? This is a daily report that is available for a nominal fee. The reports contains 7 graphs - 5 short term and 2 longer term. The service also includes special reports to provide context for the data. The report just presented was seen by subscribers over the weekend. To learn more, please click here: Premium Content. To subscribe, please click here: Subscribe.


Anonymous said...

Hey...that's only half the picture!! My point is that the Rydex graph is difficult to interpret without looking at an equivalent time period such as 2004 (new bull). Sometimes these indicators act differently depending on market conditions. I know the advance/decline line, among others, indicated a selloff was due imminently unless you normalized it according to how it reacts in a bull market. Looking back to 2004, I realized that an overextended indicator is often a sign of bullishness, and not necessarily a pullback.

Could be the same with your indicator, but there is no way to tell with the limited data.

Thanks anyway.

Guy M. Lerner said...

Anon: The data is limited in the sense that there were only 11 signals; but I thought I made it clear that the 11 signals were spread across both bull and bear markets including the 2004 time period.

As stated in the article the biggest individual trade draw down occurred in the bear market of 2001, which was surprising to me

Anonymous said...

Totally useless information.

Anonymous said...

Eight winning trades totaling 706 S&P points -- wow, that is truly an eye-popping point total from shorting, which is quite difficult to do in an upward-biased market. But of course, 2000-2002 and 2007-2009 were two of the largest, longest bear markets since 1973-74.

The Rydex data doesn't extend back that far. But I suppose the Rydex system would have had thin pickings for short trades from 1982 to 2000. Presumably Rydex traders would have been super-bullish in August 1987, though, just before the October crash.

My larger point is that we have just experienced an unusual decade -- one of the worst in stock market history. I like the Rydex system as a sentiment indicator. But being tuned on one [unusual] decade of data, it may encounter problems when and if the market reverts back to a secular, multi-decade bullish expansion.

That said, I suspect the Rydex indicator is correct in signaling a very toppy market right now. We're partying like 1999, dudes -- but should we be?