Special Report -- October 30, 2003


I have been tracking the Rydex funds' asset levels on a daily basis for several years now, and have gained some valuable insights into stock market sentiment from them. Some of you have asked me how I get the figures, and how I use the information; this report, hopefully, will answer those questions.

Rydex reports the assets in 34 of their stock funds every night at about 11:00. Ten of those 34 funds are tied to stock market indexes; six of them move in the same direction as the index, while four move inversely to them (e. g., if the S&P goes up 1%, the fund that moves inversely to the S&P will go down 1%). In addition, four of those ten funds are leveraged, and move twice as much as the underlying index (e. g., if the S&P goes up 1%, the leveraged S&P fund will go up 2% and the leveraged fund that moves inversely to the S&P will go down 2%).

There are currently about $6.5 billion of assets in those 34 funds. $2.2 billion of those assets are in the bullish index funds and $1.5 billion in the bearish funds. This is pretty small potatoes in the equity markets of today - but I am convinced, after following this data for several years, that the Rydex players reflect hedge fund activity in general, and the Rydex numbers thus represent the tip of an immense iceberg. Since hedge funds are the dominant players in the stock market at the present time, insights into their behavior - as measured by actual transactions, not just opinions - can be valuable indeed.

First, a note of caution. Many analysts use indicators based on the asset levels of just some of the Rydex funds, and there are some serious pitfalls with this. Probably the most widely-followed Rydex indicator, for example, is the Nova/Ursa ratio, which compares assets in the "long" S&P fund to assets in the "short" S&P fund. Assets in the long S&P fund, though, are currently just $236 million - only 10% of the total bullish fund assets. This, I submit, is too small a sample to be meaningful. Other analysts compare total bearish fund assets to total bullish fund assets. This, however, introduces a longer-term distortion; assets in the "long" NASDAQ fund fell from a peak of $3.7 billion in 2000 to under $400 million last October, and this ratio thus turned positive well before the actual bottom of the bear market. Still other analysts follow just the money market assets - but assets in the money market fund have been unusually high all year; they are currently $1600 million, with a range of $1465-$1834 million in 2003. I have no idea why this should be (the fund yields only .13%), but it is, and just taking assets in the money market fund as a percentage of something (total assets, total bullish assets, etc.) has been yielding unhelpful information all year. We have tried to get around these pitfalls by measuring the Rydex asset levels in several different ways (see "A New Indicator: The Rydex Sentiment Composite") - but we also track the flows in and out of the ten index funds every day, and think that there is valuable information in that data.

Here's how we calculate those inflows and outflows.

This is a copy of our Rydex worksheet from Wednesday, September 17. (You may want to download it and print it out to make it easier to follow this discussion.) The funds are listed in the order in which Rydex reports their assets every night, and the assets are listed in millions and tenths of millions of dollars. Europe, for example, had $9.7 million in assets on September 16th, Japan had $85.2 million, and so on. The one exception is the money market fund (the fifth one down), where assets are reported in millions of dollars; Money Market assets were thus $1603 million on this particular Tuesday.

We've identified Rydex's ten index funds in the left-hand margin: the six bullish index funds are marked with a "+" and the four bearish funds with a "(O)". We've found the inflows and outflows from the bearish funds to be the most helpful information of all, and this is how we calculate that number:

On Monday, the 15th, total bearish fund assets were $1520.2 million. The market went up that Tuesday, so the net asset values per share of the bearish funds went down. When we multiply Monday's assets by Tuesday's NAV changes, we get a new bearish fund asset total of $1476.1 million. But - the actual assets in the four bearish funds on Tuesday, as reported by Rydex, were only $1428.7 million. The shortfall -- $47.4 million - means that $47.4 million was taken out of Rydex's bearish funds that Tuesday.

A market rally can be greeted by players either selling short into it (which would mean an inflow into Rydex's bearish funds) or covering short positions (an outflow). In this case the Rydex players responded to the Monday rally with skepticism - by putting money into the bearish funds. And, since I am convinced that the Rydex players reflect hedge fund activity in general, this meant that hedge funds - the group that dominates market activity these days - shorted into Tuesday's strength. All other things being equal, this suggested that the rally was likely to continue over the short term (which, indeed, it did).

One day, of course, does not a trend make - but we have found that consistent shorting into strength (net inflows into the bearish funds) usually indicates that a very good short-term rally is underway. Further, the "very good short-term rally" tends to continue until at least some short-covering (reflected in a net outflow from Rydex's bearish funds) takes place. We have also noted that, in the past, it has sometimes taken as long as two weeks for a trend in the money flows in or out of the bearish funds to be reversed.

Even more importantly: if there have been a series of days with inflows or outflows from Rydex's bearish index funds, the subsequent price trend usually is not reversed until the total inflows or outflows have been largely offset. For example, if there have been net inflows of $500 million into the bearish funds over a ten-day period, which usually reflects shorting into a decline, the subsequent rally will usually keep going until $300-$400 million has come back out again.

We report these flows in our Daily Updates whenever they reflect something that is significant. Hopefully, this report will help you better understand how we get those numbers - and why we think they are worth following.

-- Walter Deemer