bonus orb
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7/27/2019 Bonus Orb
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Last year earnings growth contributed very little to the return of the market. Most of the gain that the market
experience was the result of investors being willing to pay more for earnings. This is referred to as multipleexpansion. Investors felt better so they were willing to pay a greater valuation for earnings. Positive investor
sentiment drove the market higher.
Unfortunately sentiment is mean reverting and extreme positive investor sentiment invariably leads to marketcorrections.
The charts below are various measures of investor sentiment that allow is to gauge how extreme investor
sentiment has become.
The Rydex family of mutual funds is primarily used by traders. They fund family has both long (make money
when the market goes up) and short (make money when the market goes down) funds. By looking at the ratioof dollars in the long funds as compared to the short funds you can gauge investor sentiment. Unlike a survey,
the Rydex Ratio is based upon dollars invested.
On December 30th the Rydex Ratio reached an all time high 6.5 times more dollars in the long funds than in theshort funds. This was a new all time high for the ratio. Corrections are typically proceed by the ratio being 5 orgreater.
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On December 4th the ratio of dollars in equity mutual funds and equity ETFs to dollars in money market funds
hit an all time high. While the argument can be made that the low yield on cash is probably driving this ratio,the fact remains that it is an indication that investors are pretty much "all in" on equities.
This is another look at the ratio of money market funds to equity capitalization. Currently the value of money
market funds is less than 3% of total stock market capitalization, which is an all time low. Once again this is probably being driven by low yields on cash. But once again, just as with the chart above it is an indication on
how much investors are "all in" with equities.
It is not just retail investors who have an extreme in positive sentiment, the professional class does also.
While most retail investors do not hedge their equity positions, many professional investors do. The Equity
Hedging Index is a measure of the percentage of equity hedges in place relative to long equity positions. Lowlevels of equity hedging is a sign of complacency (extreme positive sentiment). On Jan 8th the Equity Hedging
Index reached the 2nd lowest level every and is at the same approximate level that preceded the summer of
2011 decline.
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Another sign of complacency is the extremely low level of the financial stress indexes. As of Jan 20th the
various financial stress indexes that make up composite stress index reached the lowest level every. What
happens when financial stress is very low is that hedge funds tend to ramp up leverage. When leverage is
increased and hedging is decreased (chart above) it creates a situation where volatility increases and even smallmarket declines lead to forced selling.
The other times where the financial stress indexes were this low all preceded market declines.
The next chart is a measure of buying climaxes. A buying climax happens when intra-week a stock reaches a
52 week high and then closes lower than the low close than the prior weeks close. Buying climaxes are though
to indicate smart money in the market getting out positions.
Whatever the reason for buying climaxes, a high level of buying climaxes happens before market
corrections. The prior week saw largest number of buying climaxes in the last 10 years.
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Similar to buying climaxes are price reversals. The typical pattern for a price reversal is as follows. The market
makes a high, then the market sells off, in that sell off the market goes below an earlier level. The idea behind
price reversals is that they indicate when the smart money is taking profits and leaving the market.
The chart below is constructed using the following 3 parameters.
1. The market was within 0.5% of a 52 week high
2. The market had a one day sell off of at least 0.75%.3. That sell off dropped the market below all closes for the last 5 days.
This chart goes back to 1928. The level of price reversals over the last 12 months has been the highest ever.
While it is absolutely true that the market does not have to have a correction, the history of the market says that
it always has.
Every measure of positive investor sentiment that I know of is at an extreme and some of them are at extremes
never before seen. If the market does not have a correction soon, then it is unlikely to correct until we have
recession induced bear market.