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Sentiment has traditionally been measured by taking polls of selected groups of investors, advisors, investing professionals, etc. There have been and still are problems associated with this methodology: (1) The polls are normally taken over a period of several days, during which time market movement and investor outlook can change radically; (2) The responses are strictly subjective, reflecting the emotional status of the person being polled, not necessarily his/her investment position.
The idea behind using sentiment indicators is that we are trying to determine when investors have reached a saturation point of bullishness or bearishness. For example, tops are formed when everybody who is going to buy has bought, and bottoms occur after there is no one left to sell. Using subjective measures like sentiment polls makes it difficult to determine exactly when these extremes have been reached, and polls have never been particularly good for bottom or top picking. I have always maintained an awareness of sentiment, but have been reluctant to make it one of my primary decision-making tools.
THE RYDEX ASSET RATIO
Rydex is an unusual mutual fund company in that it publishes the total dollar amount of assets in each of its funds on a daily basis. This makes it possible for us to analyze sentiment based upon what investors are actually doing with real money. We do this by calculating a daily bear/bull asset ratio and monitoring the relationship between assets in the two types of funds.
When the first Rydex Asset Ratio was invented several years ago, it was based on two very small mutual funds -- URSA (bear) and NOVA (bull). Because of the small amount of cash involved (and, presumably, the small number of people using the funds), it was subject to extreme movement in either direction, and I considered it no more reliable than sentiment polls. Things change, and we have to constantly question the basis of our beliefs. In the case of Rydex, the company has added dozens of new funds. Where a few years ago total assets in the two Rydex funds might have been a few hundred million dollars, today Rydex has over 40 funds with billions of dollars in assets. This is a very stable platform from which to derive indicators.
This ascension to "critical mass" has made the Rydex Ratios much more useful as indicators measuring sentiment. Rather than measuring someone's vague opinion about market direction, the Rydex Ratios present specific information about where people are actually putting their money. This is a vote that really means something. Also, we can compare current investing patterns with previous periods and determine when bullish or bearish saturation points are being reached based on an objective, quantitative measuring stick.
Now let's discuss specific components of the Ratio calculations.
Bull Funds: All index funds that are long the stock market.
Sector Funds: All sector funds that are long the stock market. Precious Metals, Government Bond, JUNO (bearish on bonds), Commodities, Strong Dollar, and Weak Dollar mutual funds are not included because we consider these funds to be representative of separate markets.
Bear Funds: All index funds that are short the stock market.
Money Market: Since money market funds are not invested in bull funds, we consider them to be a mildly bearish vote.
Rydex Asset Ratio Formula:
(Money Market + Bear Fund Assets) / (Bull Fund + Sector Fund Assets)
THE RYDEX CASH FLOW RATIO
In August 2004 Decision Point introduced the Rydex Cash Flow Ratio, which is based upon cumulative cash flow instead of total assets.
Cumulative Cash Flow (CCFL): We calculate and chart daily and cumulative net cash flow, which is the actual cash entering and leaving each fund in the Rydex group of funds. This is done by calculating the amount that total assets in a fund should have changed based upon the percentage change of per share net asset value (NAV), assuming that no cash was added to or taken out of the fund. We then subtract this amount from the actual amount of total assets in the fund, and the result is the daily net cash flow. We keep a cumulative total of the daily net cash flow. Total asset value tells us how much money is in the fund. Cumulative Cash Flow tells us how much cash was actually moved in or out of the fund. For example, on 8/18/2004 total assets in Rydex Bear Funds were $2.14 billion, but Cumulative Cash Flow totaled $3.09 billion. This means that bearish investors had lost about 31% of the amount they had invested in Rydex Bear Funds since April 1998, which is where our calculations begin.
NOTE: The results from independent calculations of CCFL will differ unless the starting point is the same. Decision Point's deep historical data for Rydex assets results in larger CCFL current numbers, which results in more stable CCFL ratios. Also, as CCFL totals increase over time, the Ratio will become less volatile, and the range will narrow.
Rydex Cash Flow Ratio Formula:
(Money Market + Bear Funds CCFL) / (Bull Funds CCFL + Sector Funds CCFL)
We think that the Rydex Cash Flow Ratio is a dramatic improvement over the Rydex Asset Ratio, because it uses an estimate of money that has been committed to bull and bear funds, so it is a more accurate reflection the actual psychological extremes than asset levels are.
There are three components to CCFL: (1) Money that is worth as much as or more than when it was deposited; (2) money that is worth less than when it was deposited; and (3) money that has been abandoned -- the investor sold the shares for less than they cost. For example, an investor buys 10 shares for $100, redeeming the same 10 shares later for $70 -- a $30 loss. That $30 remains forever part of the CCFL total, and for this reason CCFL will trend upward over time. Consequently, we should consider that over a period of months a certain portion of CCFL will become "stale" as regards its being a reflection of investor psychology.
The chart below gives us good examples of extreme readings over a range of market conditions. When we compare the two Rydex Ratio indexes, we can see that the Cash Flow Ratio shows more rational and consistent levels of support and resistance.
HOW TO USE THE RYDEX RATIOS
The Rydex Ratios can be used to gage sentiment in three time frames, and for each we look at different elements. In our discussions, please note that the Ratio charts have a reverse-scale display to make interpretation of the charts more intuitive by giving overbought and oversold readings the same orientation as on the price chart. We will refer to high/low, up/down based upon that orientation.
Short-Term Analysis: For the short-term it is best to view the Ratios within the context of some kind of overlay. Either the Cash Flow or Asset Ratio can be used. We use a 20-EMA with Bollinger Bands. On the chart below, note that short-term excesses of bullishness or bearishness are identified when the Ratio tops or bottoms near the limits of the Bollinger Bands.
You will also notice that, when the market is trending, the Ratio tends to stay on one side or the other of the 20-EMA. During these periods, the 20-EMA becomes support or resistance, and enforces more narrow limits of what is considered overbought or oversold.
Contact with the Bands is not always a sign that the move has reached a short-term limit. When the Ratio makes a sharp 20-EMA crossover, it signals a possible shift in short-term sentiment. If it subsequently begins "pushing" the Bands in the direction of the crossover, it confirms the sentiment shift, and we need to wait for Ratio topping or bottoming action before speculating that sentiment has reached a short-term saturation point.
Medium-Term Analysis: While Bollinger Bands help define short-term excesses, medium-term excesses are gauged by looking at the trading range of the ratio over a period of several months. For this we think the Rydex Cash Flow is the best tool because it presents a view of the amount of dollars that have been recently committed to bullish or bearish funds, rather than the asset value, which is the current value of funds committed.
On the chart below we can see how the Cash Flow Ratio is able to maintain a well-defined trading range for extended periods.
It is really striking how the Cash Flow Ratio has clearly detected the true state of sentiment during 2002 through 2004. For example, we can see a sharp rise in bullish sentiment coming off the March 2003 price lows. Then by May 2003 we can see sentiment peak and begin to turn bearish. I remember because I was there. People didn't believe that a bull market had begun. They became progressively more bearish in June and July, and, when the market had a small shakeout in August 2003, the Cash Flow Ratio was as bearish as it had been in March 2003. While that may not seem reasonable based upon price movement, I think it is an accurate expression of how sentiment "felt" at the time.
Also, note how the Ratio trading range shifts downward at the beginning of 2003. This was caused by a large chunk of money moving into bear funds as the market headed down into it's final low before the bull market launched. Bearishness reached a feverish pitch at that time and it permanently altered the trading range. This could happen again in either direction if sentiment is strong enough.
Long-Term Analysis: For this time frame the Asset Ratio seems to offer a more rational picture. We can see on the following chart that the Ratio levels in 1998 are approximately the same as those in 2002/2003, coinciding with two major price lows for the market. Also note that the Ratio tops in 2002 and 2004 are approximately equal, as are the coinciding price tops. This implies that the Ratio level in 2000 will probably serve as a good benchmark for the next major market high.
The Rydex Asset and Cash Flow Ratios are useful tools in evaluating market sentiment, and, as you can see, there is something for everybody when it comes to finding sentiment indications that agree with a point of view about the market. The short-term can show bearishness, while the medium-term shows bullishness, and the long-term is neutral. Absolute Ratio levels are informative if there are historical references for those same levels, but direction and context also need to be considered. Be sure you understand the time frame reference.