A NEW INDICATOR:
THE RYDEX SENTIMENT COMPOSITE

I have been growing less and less enamored with the Fidelity sector fund cash/asset ratio of late; it's become a little too insensitive, for some reason or another, to be as helpful as it's been in the past. (In September, for example, the cash/asset ratio only got up to 6.4%, which was below April's 6.8% peak despite a much more intense and emotional wave of selling in the market.) I've therefore also been following the Rydex fund data for over a year now, and think the time has come to add it to our daily updates and weekly reports.

Rydex is a unique fund family that tends to attract aggressive investors. Their fund group includes four index funds that mirror the S&P and NASDAQ Composite on both the long and the short side. They also offer four dynamic funds that move up or down twice as fast as their underlying indexes, and it is the dynamic and short funds that makes Rydex unique. The nine index funds (a ninth fund moves up and down 1.5 times as fast as the Russell 2000) currently have $2.3 billion in assets, $600 million of which is in the four bear funds. Rydex also offers 18 sector funds that have about $1 billion in assets among them, and their $1.4 billion money market fund brings their total assets to about $5 billion.

The flow of money in and out of these funds would seem to be an analyst's dream, but there are some pitfalls in using them as a sentiment indicator. $5 billion, for example, is a big number, but it's not nearly as statistically valid as we would like (Fidelity has five times as much money in their sector funds alone). In addition, distortions can materialize fairly easily in the data; the Rydex OTC fund, for example, had over $3 billion in assets - nearly half the Rydex total -- in its heyday compared with only $1 billion now, and the persistent decline significantly distorted total-asset ratios. But there IS a lot of useful information in the daily Rydex numbers; after following them for many months, I think the best way to minimize the distortions, yet still have a useful indicator, is to take a composite of three ratios. The three ratios are:

1. Bear funds/total assets. The assets in the four bear funds as a percentage of total Rydex assets.

2. Bear funds + money market fund/total assets. The same as above, but it adds the money market fund (which is more than twice as big as the four bear funds) to the numerator.

3. Dynamic short funds/total dynamic fund assets. This is the purest sentiment reading we can get, but with only four funds to work with, and only $600 million in assets among them, the sample is too small to stand alone.

After calculating the foregoing three ratios, we then "normalize" them by taking them as a percentage of their highest and lowest reading in the past year. A reading of 100, for example, indicates that the ratio is the highest (most bullish) that it has been in the past year. A 50 reading means the ratio is halfway between its highest (most bullish) and lowest (most bearish) readings of the past year, 75 is three-quarters of the way between its highest (most bullish) and lowest (most bearish) readings of the past year, and so forth. Finally, we divide the three ratios by 3 to get an average. We call this average our Rydex Sentiment Composite, and have attached a chart of it to this report.

The Rydex Sentiment Composite has some advantages and some disadvantages. Unlike Fidelity's data, for example, the data is available on a same-day basis, so we know every night what the Rydex players did that day. The indicator, though, is pretty volatile on a day-to-day basis, and the fact that it is "normalized" means it can stay at 100 (or 0) for a prolonged period if the ratios set a series of new highs or lows. In following the data, however, I've found it DOES provide a useful insight into trading activity, and am thus going to include the Rydex Sentiment Composite (along with the Fidelity sector fund cash/asset ratio) in our daily updates and weekly statistical summaries from now on.

In an attempt to keep this explanation relatively simple, I've kept it relatively brief. Just remember: Up is bullish, down is bearish; increases are bullish, decreases are bearish; and the closer to 100 the Rydex Sentiment Composite is, the more bullish it is. If you have any questions at all, though, either now or later on, don't hesitate to give me a call.

Walter Deemer