Friday , 19 July 2019


Investors are Oblivious to the Market’s Downside Potential

This article focuses on indicators that are of medium to long-term relevance to prospective stock market returns telling us something about the likely duration and severity of the bust that will follow on the heels of the current market mania.

1. Performance of RYDEX Funds

The first chart is an update of the current situation in RYDEX funds. Despite their small size, these funds have always represented a quite accurate microcosm of general market sentiment.

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An RYDEX overview:

  • RYDEX money market fund assets have recently declined to new all-time lows;
  • the pure non-leveraged bull-bear fund ratio is back above 29…At the top of the tech mania in early March 2000, this ratio peaked at roughly 17;
  • the amount of assets in RYDEX bear funds demonstrates…that at this stage almost no one expects that the market could suffer a serious slump.

2. The Leveraged RYDEX Bull-Bear Ratio

The next chart shows the leveraged RYDEX bull-bear ratio. Although it is well off its 2018 peaks, it remains in nosebleed territory at a factor of 16.4.

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The leveraged RYDEX bull-bear ratio compares assets in leveraged bull and bear funds and is a testament to the intensity of speculation on a rising market. Its all-time low was made in June 2003 at 0.20; in November of 2008, it bottomed at 0.40. Both were quite propitious times to go long equities – the same can probably not be said of the current juncture.

3. Mutual Fund Cash-to-Assets Ratio

The next chart is a very long term chart of the mutual fund cash-to-assets ratio. In late December 2018, it fell to a new all-time low of 2.9 (i.e., a mere 2.9% of all mutual fund assets were held in cash). In short, not even a rapid and harrowing 20% correction was able to faze fund managers. This shows how deeply ingrained the bullish consensus has become.

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Mutual fund cash is at an all-time low compared to total mutual fund assets…[because] everyone has become convinced that the central bank will always be able and willing to rescue the market when it falters. This is a dangerous attitude.

4. Ratio of Assets Held in Retail Money Market Funds to the S&P 500 Index Market Capitalization

The next chart shows the ratio of assets held in retail money market funds to the market capitalization of the S&P 500 Index. This chart is very similar to the mutual fund cash-to-assets ratio and illustrates that a pervasive and deeply ingrained bullish consensus is just as prevalent among retail investors as it is among fund managers.

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…In recent years this percentage has declined to levels far below previously recorded low points. Evidently, retail investors are not exactly concerned about the market either.

5. Margin Debt

Lastly, we will take a look at margin debt. The first chart shows margin debt in nominal terms.

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Apart from the fact that margin debt has also streaked to unprecedented highs in 2018, it has actually failed to rebound in the course of the recent rally. This constitutes a bearish divergence – as several previous major market peaks indicate, margin debt very often (but not always!) tops out before the stock market indexes peak. The years 1937 and 1973 were notable exceptions to this rule, as margin debt peaked with a considerable lag in both cases.

6. Cumulative Growth of Margin Debt Compared to the Value of the S&P 500 Index

The next chart compares the cumulative growth of margin debt and the value of the S&P 500 Index in real terms (i.e., adjusted for CPI) since 1997.

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In real terms margin debt has grown to a far greater extent than the market capitalization of the SPX.

7. Investor Credit and the Market

The growth in margin debt represents a considerable threat to the market, as aggregate credit balances held by investors in brokerage accounts are deeply negative (they have slightly improved since 2018, but remain near historic extremes).

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…Obviously, these extremely large negative credit balances will be prone to exacerbating pressure on stock prices once a downturn crosses the thresholds required to trigger margin liquidation...

When the Long Term Becomes the Present

…There are a number of good reasons to be concerned that we are quite close to the point in time when the long-term sentiment and positioning indicators shown above begin to exert their effects… 

Editor’s Note: The above excerpts* from the original article have been edited ([ ]) and abridged (…) for the sake of clarity and brevity. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.

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(*The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.)

One comment

  1. Hmmmm, Lorimer,
    Downside potential for housing/real estate.
    Downside potential for the market.
    Upside potential for precious metals.
    Does guidance get any clearer?