The Rydex Ratio has reached a level where it is telling us that sentiment is too bullish, and that stock prices are vulnerable.
The Rydex Ratio gives a view of sentiment extremes using using the totals of assets in Rydex mutual funds. It is calculated by dividing Money Market Assets plus Bear Funds Assets by Bull Funds Assets. We display the indicator with the scale reversed so that interpretation can be more intuitive. The unique feature of the Ratio is that it measures sentiment based upon where people are actually deploying real money, not just an opinion poll.
Currently, the Ratio has reached the top of the normal extreme range, and at this level we should be looking for a price decline. But wait, there already has been a price decline from the September top, and the Ratio has moved even higher during the price pullback. This is not a rational response by investors, and suggests there will be a stronger downside reaction when investors decide that buying into a decline isn't working.
Conclusion: When Rydex Ratio readings reach current levels, prices become vulnerable to stalling or an outright correction -- not always, but more often than not. In this particular case the situation seems unusually precarious because bullishness has increased even in the face of a price decline.
