Interpreting Dumb Money Actions

Analyzing the dumb money's actions (what these investors are doing) will provide a fairly accurate investor sentiment reading of the market. There are all sorts of investor sentiment gauges out there, some shorter term and others longer term. There are several sentiment gauges that I like best and that line up well with the "wind at your back" method outlined in Chapter 6.

The first sentiment indicator I will review here is the "Rydex Cash Flow Ratio." Rydex is a mutual fund company that has both a bear and bull funds for the S&P 500 and the Nasdaq. It publishes the total dollar amount of assets in each fund on a daily basis. This makes it possible to analyze sentiment based upon what investors are actually doing with real money.

Prior to 2003 the Rydex funds had relatively small amounts of cash and were subject to extreme movement in either direction. Things have changed since then, and after 2003 Rydex has more than 40 funds with billions of dollars in assets. This provides a very stable platform from which to derive accurate sentiment readings. Since Rydex has both bullish and bearish funds, a trader can see which way the public is investing as cash flow is going from bullish funds to bearish funds or vice versa. Rather than measure someone 's opinion about market direction, the Rydex Cash Flow Ratio presents information as to whether people are actually putting money where their mouths are.

Rydex's most popular funds are based on the S&P 500 and the Nasdaq 100. Rydex makes the asset levels of these funds available to the public each evening. This information allows traders to determine group sentiment on the market by observing where these investors are placing their money. Like all contrary indicators, when these investors become so optimistic that the assets flowing into the bullish funds soar higher, it is usually a good sign that the market is nearing a top and soon will see prices decline.

Reading the Rydex Cash Flow Ratio Figure 7.9 displays the Rydex Cash Flow Ratio in a chart format (courtesy of Decisionpoint.com). Using this chart format, traders can compare current patterns with previous periods in time to make a determination of whether the current level is bullish, bearish, or neutral.

The upper half of Figure 7.9 shows the S&P 500, and the lower half is the Rydex Cash Flow Ratio. Carl Swenlin of DecisionPoint.com came up with a very useful calculation for the Rydex Cash Flow Ratio. He calculates and charts daily and cumulative net cash flows, which is the actual cash entering and leaving each Rydex fund. This is done by calculating the amount that total assets in a fund should have changed, based upon the percentage of change per share of 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. He abbreviates this formula by:

Bear CFL + MM/Bull CFL where CFL stands for cash flow level, and MM stands for money market.

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FIGURE 7.9 Rydex Cash Flow Ratio Chart Displays Ratio Readings at Lows in the S&P

Source: Chart courtesy of DecisionPoint.com.

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FIGURE 7.9 Rydex Cash Flow Ratio Chart Displays Ratio Readings at Lows in the S&P

Source: Chart courtesy of DecisionPoint.com.

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FIGURE 7.10 Rydex Cash Flow Ratio Chart Displays Ratio Readings at Highs in the S&P

Source: Chart courtesy of DecisionPoint.com.

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FIGURE 7.10 Rydex Cash Flow Ratio Chart Displays Ratio Readings at Highs in the S&P

Source: Chart courtesy of DecisionPoint.com.

This formula determines money flows in and out of the bullish and bearish Rydex Funds for the S&P 500 and gives an accurate sentiment view.

Referring to Figure 7.9, notice that since 2003, bottoms have formed in the S&P 500 when the Rydex Cash Flow Ratio reached near the 1.05 range. (Note the arrows pointing up from the 1.05 level). Readings in the 1.05 range suggests there is little interest on the long side for the S&P 500 among the public investor (dumb money), which is a bullish sign.

Figure 7.10 shows the Rydex Cash Flow Ratio where tops can form when this ratio reaches 0.75 or less. I have drawn arrows up to the S&P 500 to show this correlation with Rydex Cash Flow Ratio readings below 0.75. Notice that this particular sentiment gauge does not work as well for picking tops as it does for bottoms. However, we will turn to other sentiment tools that do work well in helping to pick tops in the market.

Put/Call Ratio-OEX Open Interest Ratio Another sentiment indicator that is useful in picking turns in the market is the "Put/Call Ratio-OEX Open Interest Ratio." OEX is shorthand for the S&P 100 Index, which is made up of the 100 largest companies in the S&P 500. Open interest is defined as the total number of option contracts outstanding. The open interest ratio takes the total put open interest and divides it by the total call open interest. Therefore, a ratio of 1.80 indicates there are 1.8 put positions for every 1 call position.

The OEX put/call open interest ratio should be considered a noncon-trarian sentiment indicator. Evidently, there are some very astute OEX option players out there who have got it right. Therefore, this sentiment indicator reflects the smart money. When this ratio becomes extreme expect a turn in the market.

Figure 7.11 shows that when the Put/Call Ratio-OEX Open Interest Ratio reaches 1.80 or higher, traders can expect the rally to end. At that point, either a sideways trading range or a market reversal would follow. The duration of time for this correction or consolidation phase should last a month or longer.

In Figure 7.12, when the Put/Call Ratio-OEX Open Interest Ratio reaches readings near 1.0 or lower, traders can expect a rally to begin shortly in the S&P 500. When the Put/Call Ratio-OEX Open Interest Ratio stays near 1.0 or lower for an extended period of time, the rally phase in the S&P 500 is expected to be extended.

FIGURE 7.11 Put/Call Ratio—OEX Open Interest Ratio Readings at or Above 1.8 Indicate Market Highs

Source: Chart courtesy of www.SentimenTrader.com.

FIGURE 7.11 Put/Call Ratio—OEX Open Interest Ratio Readings at or Above 1.8 Indicate Market Highs

Source: Chart courtesy of www.SentimenTrader.com.

FIGURE 7.12 Put/Call Ratio—OEX Open Interest Ratio Readings Near Lower Indicate the Beginning of a Rally Source: Chart courtesy of www.SentimenTrader.com.

FIGURE 7.12 Put/Call Ratio—OEX Open Interest Ratio Readings Near Lower Indicate the Beginning of a Rally Source: Chart courtesy of www.SentimenTrader.com.

Figure 7.13 illustrates the next sentiment indicator, "All-Index Small Speculator Positions." These statistics come from the Commodity Futures Trading Commission (CFTC), which is the regulatory body responsible for the futures industry. Essentially, this chart shows what small S&P commodity trader positions are. Normally, these players have the most long contracts, and therefore are the most bullish when the S&P 500 market is near a top, as we would expect. When positions held by the small S&P 500 speculators reach the 28 range, as Figure 7.13 shows, the S&P is near a top.

Likewise, these small S&P 500 speculators have a history of being heavily short at exactly the wrong time as well. Figure 7.14 shows that when small speculator positions reach 15 on the chart, the market is usually at a low.

Investor sentiment gauges help to find extreme highs and lows in the market for the shorter-term time frames, which lines up well with the

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FIGURE 7.13 All-Index Small Speculator Positions Indicator Indicates When the Market Is Near a Top with a Reading Around 28 Source: Chart courtesy of www.SentimenTrader.com.

"wind at your back" method described in Chapter 6. To have confidence in a trading plan, traders need as much confirmation as possible of a top or bottom. By layering your technical analysis with investor sentiment gauges, you can become more confident of determining turns in the market to trade. If you don't do the necessary study to find market direction, you could find yourself in a precarious position—like standing on one foot at the edge of a cliff with a strong wind blowing. Any misbalance could hurt you.

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