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7/23/2008
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Knowing what the other participants in the stock market are doing with their money is critical to success. Identifying when the “herd” has become too bullish or bearish or knowing where the “smart money” is going is very important especially at market turning points. “The Wrong Money Indicator” With regards to investor sentiment, four indicators are monitored that represent four different segments of the investing public. The Investors Intelligence poll seeks market opinion from newsletter writers. The American Association of Individual Investors polls individual investors. The Market Vane Bulls polls investment advisors, and the put-call ratio attempts to quantify the behavior of option players. Anecdotal evidence would suggest that these market participants are wrong in their opinions more than they are right. The indicator we use is an aggregate indicator that weighs and quantifies the opinion of these four different market participants. A simple trading system is designed to buy the market when investor opinion is too bearish and sell the market when participants are too bullish. The results are presented in Table 1. Table 1.
Thus the simple idea of “buying them when no one wants them” is actually pretty profitable. But like most indicators that quantify the market environment, we can actually improve upon them by adding a methodology that improves entry and exit efficiency. Such a system that combines investor sentiment with the Price Structure Analysis is shown in Table 2. Table 2.
Knowing where the “Smart Money” is putting their money is very important to success in the markets. After all, you don’t want to be betting against those who are most knowledgeable and who must derive their living from the markets. A composite indicator, aptly named “The Smart Money Indicator”, has been developed that assesses the activity of those traders most in the know. This indicator is derived from three sets of data. The first is the public to specialist short ratio. This ratio increases in value when either the public bets too heavily against the stock market or when New York Stock Exchange specialists (“smart money”) have decreased their short exposure. Either way, you don’t want to bet against the NYSE specialists especially at extremes. To help identify extremes, the public to specialist short ratio is placed in adaptive moving bands that have a look back period of greater than one year. The second data set is the specialist short sales ratio. This value is constructed by taking the number of NYSE Specialists that are short the stock market divided by the total number of short positions in the stock market. Therefore, as the public bets more heavily against the market the “total” value increases, and the specialist short sales ratio will go down. To help identify extremes, the specialist short sales ratio is placed in adaptive moving bands that have a look back period of greater than one year. It is at these extremes that one should look to go with the “smart money” and against the public. The third component to “The Smart Money Indicator” is derived from the ratio of the volume of puts to the volume of calls in the S&P100. These OEX options traders are thought to represent a more sophisticated trader one that might be hedging a large portfolio, for example. Therefore, the OEX put to call ratio should not be considered a contrarian tool. As with the other two data sets, extremes are identified by placing the OEX put to call ratio within adaptive trading bands that have a look back period of greater than one year. Now that the indicator is constructed, how well does it perform at identifying different investment back drops. Table 3, column 1 shows a system that goes long the stock market when all three components of “The Smart Money Indicator” are at a bullish extreme. That is, the professionals are bullish but the public is bearish. The position is liquidated when the indicator returns to bearish territory, which has been defined as 2 out of 3 of the indicators being in bearish mode. Column 2 goes long the market when the public is bullish but the professionals are bearish. No money management strategy was used in either system. Table 3.
One problem with “The Wrong Money Indicator” is that it is primarily based upon the opinions of market participants and not what they are actually doing with their money. It would be nice to have a tool that allows one to see where market participants are putting their hard earned dollars. While not a reflection of the entire investing universe, the flow of assets into the Rydex Investments mutual funds may offer some insight into the thinking of investors. Rydex Investments is a family of 45 mutual funds that offers investors the ability to time the market either from the short side or from the long side. Nine of their products correlate with well known indices; they have 18 sector funds, and there are 5 inverse (or short) funds that correlate with a falling stock market. Several of their funds can be leveraged providing investors an opportunity to double their buying or selling power provided they get the direction of the market right. So what is so unique about Rydex Investments? Rydex Investments has a service where the actual asset flows are reported for each fund on a daily basis. Thus one can judge investors’ enthusiasm for the markets or a sector by the amount assets flowing to and from each Rydex investment product. Typically these market timers are wrong in the extremes, and several indicators have been designed that hopefully will capture these turning points. In general, the Rydex asset flows have served as a good tool even though there is only 5 years of data in most cases. Rydex Money Market When asset values are high in the Rydex Money Market Fund, the implication is that investors are expecting lower prices. When asset values are low, investors tend to be fully invested. The total money market asset flows are measured on an absolute basis and with a relative strength oscillating indicator. Rydex Bullish Ratio Another way to view where the money is going is to look at the total amount of assets in long only funds versus the amount of money in defensive funds (ie, the money market fund) plus funds that short the stock market. This Rydex Bullish Ratio indicator is generally bearish for higher prices when greater than 50% of the total assets are in long oriented funds. This indicator was less than 45% for much of the mini bull market of 2003 – meaning that few of these Rydex timers truly embraced the rally. Once the indicator got above 50% total assets in these long funds, the market began to put in a top. Rydex Composite Sentiment The Rydex Bullish Ratio uses the percentage of total assets in bullish funds, and this number can be compared to previous levels. In essence it is measuring the absolute levels of bullish assets. Another way to look at the data is to take a relative strength index of the amount of money in the bull funds and in the bear funds. This relative strength value is then wrapped in adaptive trading bands with a look back period of 70 days to help identify extremes in assets in both the bullish and bearish funds. Combing these relative strength oscillators with the Rydex Bullish Ratio gives the Rydex Composite Sentiment indicator. |
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