Rydex Leveraged ETF Ratio: A Market Top In Sight

They Rydex Nova/Ursa ratio is a well known indicator of investor sentiment. It measures the ratio of assets in the bullish (150% of daily S&P 500 index) with the bearish fund (-100% of daily S&P 500 index). As all contrarian measures, if we find retail traders crowing into bull funds, this is a bearish omen.

I’m sure you won’t be surprised to learn that right now the Rydex Nova/Ursa ratio is showing a preponderance of bullish interest from the retail traders that use the Rydex mutual funds. In fact, it is at the highest level since May 2008, just as the cascading bear market decline was about to unfold.

But before we rely on such data, we have to note that there is a clear migration away from mutual funds as investment and trading vehicles. According to a recent survey of 4000 US investors (with at least $100,000 portfolios) conducted by Cogent Research the proportion of investors that own at least one mutual fund has declined from 94% in October 2006 to 75% in October 2010. And the allocation investors make to mutual funds within their assets has declined from 54% to 44% in the same time period. Meanwhile ETF allocations have grown from 11% to 16%.

I showed this previous trend chart comparing the rise of ETF’s with the decline of mutual fund references in books which reflects what is happening:

Cogent Research’s John Meunier commented: “…it’s impossible to know exactly how things will play out, it’s clear that a major realignment is underway. Traditional mutual fund providers are fighting tooth and nail for a shrinking piece of real estate, while established ETF providers face a different challenge; fending off a rush of new providers in a rapidly expanding marketplace.”

As the still dominant vehicle of choice, mutual funds continue to be a great source of fund flow information and they will continue to be for a long time. But the trend is clear. So we have to start to look mutual fund and ETF flows if we want to get an accurate picture of what is happening with the fund flows.

With that in mind, I checked to see if the Rydex leveraged ETFs were confirming the signal from the Rydex Nova/Ursa ratio. Here is the bull/bear ratio for the Rydex 2x (RSU) and Rydex 2x Inverse S&P 500 (RSW) ETFs compared with the S&P 500 index:

Because these are newer products we only have a few years of data. Even so, it is clear from the available data that when we have a spike in bullishness, the market tends to underperform.

The one exception is the early weeks and months after the birth of the cyclical bull market in March 2009. The momentum catapulted the market higher in spite of the extreme bullish positions of retail traders.

The current reading is 1.63 – the highest level of bullishness since May 2009. In that instance, the S&P 500 index went sideways and corrected into July 2009. Peak to trough, the S&P 500 retraced 4%, mostly trading sideways, before resuming its upward climb.