Which Way for Wrong-Way Traders?
In mid-October, there were several signs among the measures we monitor that suggested the downside was limited and any further probes lower should be quickly regained. With the rally over the past couple of weeks, however, many of those same signs have either reversed completely or are very close to doing so. I have included some of them below.
First, the Rydex Beta Chase Index (the blue line) is a proprietary measure we compute which looks at the asset levels in various Rydex funds. We monitor which funds are getting the most assets and which are being shunned by traders. Recently, the index spiked up to 23, which means that these traders were 23 times more likely to trade a high-risk fund than a low-risk fund, a sure sign of excessive speculation that is in fact a new record for the indicator.
The second chart (the green line) is a 5-day moving average of the equity put/call ratio as provided by the Chicago Board Options Exchange (note the inverse scale). This isn't my favorite put/call measure, but it has been quite effective so far this year at the extremes. Currently, we see that traders have exchanged about 166 calls for every 100 puts, a level that has coincided quite well with other trips to the top of the trading range in the S&P 500.
Lastly, the red line on the chart is the 5-day average of odd lot purchases. These are buys executed for fewer than 100 shares at a time. While there is some debate about whether this volume is being skewed by professional traders trying to skirt regulatory hurdles, I don't think that's much of a factor. If we look at the chart, we see that both other times we have seen a weekly average of more than 13 million shares on the buy side (early March and mid June), the S&P topped out soon thereafter.
The red dots on the chart highlight the only other time this year - June - when all three contrary indicators hit extreme levels in a quick succession. Now we are seeing all of them become extreme at the same time. Whether it is due to relief over the election, or belief in a strong year-end rally, whatever the reason behind the numbers the objective fact is that these readings normally accompany market weakness going forward. I continue to believe we hit an intermediate-term low in August, so I'm not particularly enamored with being short the market, but I do think now is a high-risk time to be trying to enter new long positions in anything that tracks the broader market closely.
Why not be short if I think there is a lot of risk in being long? Because despite "everyone" knowing about the positive seasonality for the next few months, it continues to work quite consistently. After a very tough year for trend-followers, I believe if we break out to the upside, in November, with many funds trying retain clients, we could see quite a run. So I think we'll take a breather, but I don't want to get rolled over by trying to go short (except maybe very short-term ins and outs). As always, this is not advice just one guy's opinion.
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