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Not as Bad As It Could Be


Would those guys PLEASE get off my side!


You may recall me writing about something I called the SPY Liquidity Premium on July 1st. At the time, I mentioned that the Premium was very low, telling us that traders felt no need for the relative safety and liquidity of the two most popular exchange-traded funds. That was a warning sign and it turns out it was a pretty good one, as again the market declined in the face of such complacency.

Last week, the premium reached an extremely low level once again, and in combination with data such as odd lot purchases (which had been abnormally high), I thought option expiration last Friday would most likely provide the catalyst for the deepest correction we had seen since the rally began last month. All of that is rear-view mirror stuff, but it's necessary background information - now that we are in the midst of the correction, there are actually some positive signs that I think should be noted.

Over the past few days, we have seen a dramatic shift in the behavior of odd lot traders, as they now scramble to protect themselves against falling prices. We are also seeing put/call readings remain extremely high considering the run-up in prices). But most notably is the action in the Rydex mutual fund family, as those traders never really believed in the rally to begin with and are using the recent action to become even more defensive.

The chart below shows the total assets in the leveraged Rydex bull funds. These funds gain (or lose) $2 for every $1 the S&P 500 and Nasdaq 100 gain (or lose). At the August lows, there was $732 million invested in those funds, which had been the lowest amount yet this year. But look at the assets since the rally began - they didn't really budge, and now have dropped back again. In fact, as of last night the assets were at $722 million - $10 million below what they had been at when the S&P was about 40 points lower.

That is compelling evidence to me that this group of traders is extremely hesitant about buying into the rally (maybe they've already been burned too many times this year alone). Insomuch as these asset flows are an accurate reflection of a broader group of traders, which I believe they are, then we may be in for one of the shallowest corrections we've seen in 2004. I don't think it's quite over, but if we continue to see readings like this, I don't think the August lows will be breached.

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