Chart of the Day: Rydex Ratio Flashing Caution Signal

Yesterday I mentioned that one of the sentiment indicators I follow was flashing a yellow caution light. That ratio is the Rydex Nova/Ursa ratio, which measures flows into the Rydex bullish funds vs. the Rydex bearish funds. Basically, it measures what the Rydex market timers are doing in terms of getting longer the market when they're bullish, or short the market when they're bearish.

Like many of the sentiment indicators, we look at it from a contrarian standpoint, such that when the heard has all moved to the bullish side of the equation, sentiment has likely become too bullish and leaves the market vulnerable to a pullback.

You can see in the chart below that the Nova/Ursa ratio has recently spiked to a 7-month high. The last time is hit these levels was back in September 2009, before it topped out. Roughly a week after the ratio topped, the S&P 500 also topped (briefly) and gave up 50 points over the next 2 weeks for a 5% pullback.

Could the same thing happen this time around? Anything is possible. I usually like to look for confirmation in more than one indicator, and different indicators reach extreme levels at different times.

Right now, this is the only indicator rising this quickly, although I mentioned the ISEE call/put ratio did flash a couple days of overly bullish readings. Also, the VIX continues to hit new low levels, which also highlights high levels of complacency among traders. So this is something to put on your radar, and watch for confirmation signs from other indicators.

Trading comment: I posted that I have raised some cash recently, to get positioned for a potential pullback. At the same time, this 'stair-step' market (as I have called it) doesn't go down very easily. It continues to feel like each small dip is quickly met with buying demand. But yesterday's small rally came on lighter volume, while down days have come on higher volume recently. So I prefer to tread lightly here, still bullish, but cautious.