One of the main tasks of monitoring investor sentiment is determining when we are seeing excessive speculation (either upside or downside). There are numerous ways to do this, of course, but recently a new way was introduced, and it's one of the most interesting areas of sentiment analysis.
The Rydex mutual fund family offers a broad array of funds, including innovative funds that are leveraged as much as 2-to-1, and other funds that run counter to the market. For example, the Rydex Tempest fund is leveraged 200% to the short side - meaning that when the S&P 500 declines by 1%, this fund should RISE by 2%. This has opened up a new category of trading vehicle to those interesting in speculating (or hedging) on broad market moves without shorting stocks or using something like futures and options.
Each night, Rydex updates the asset levels of each of its funds and allows the public access to these numbers. This gives us an exciting insight into what these traders are actually doing with their money (as opposed to what they are SAYING they are doing with their money). To see how traders feel about daily market movements, we can monitor the asset flows among the various funds.
One truism about investor behavior is that they become emotional at the extremes. They become overly optimistic when prices rise, and fearful when prices decline. When they are feeling extremely optimistic, they usually want to make the most bang for their buck, so they move their money into the funds with the highest beta, and out of the "safe", low-beta funds. I created an index from this behavior using the Rydex asset flows, which I dubbed the "Beta Chase Index". The index will rise if assets are flowing into the high-beta funds and/or out of the low-beta funds. When it reaches a very high level, then we know that speculation is hitting an extreme. When it drops and becomes low, then we know that these Rydex traders are not feeling particularly confident of future market direction. This index is shown below.
We can see that when the index (the blue line) peaks over 3.0, the market has had trouble gaining ground afterward. Currently, it is giving us a reading of 4.64, which is one of the highest readings seen over the past couple of years and tells us that these Rydex fund traders are betting heavily on further upside in a very aggressive manner.
Like any indicator, this one has limitations, the most serious of which is that the data has only been around for a few years, so we don't yet know how it will act in a long-term bull or trading-range market. Also, with a limited amount of data, it's relatively difficult to determine what, exactly, is extreme. But from what we do know, investors tend to become the most greedy when they are the most comfortable. And right now, these traders appear to be quite comfortable.
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