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Video of the Week: Man Has Got To Know His Limitations

This week's Chart of the Week video looks at a unique indicator: the Rydex Bullish and Leveraged to Bearish and Leveraged Ratio. The Rydex asset data is sentiment data, and it is based upon real asset flows.

So let's get technical.

Like Pavlov's dogs, investors have become conditioned to the machinations of Federal Reserve Chairman Ben Bernanke. When Ben barks....I mean talks, investors listen. In fact, Ben doesn't even have to speak anymore as investors, like the obedient and smart dogs they are, have learned the drill so well over the past 4.5 years that sell offs have become shallower and shallower as time has gone on. This can be seen in this weekly chart of the SP500. Market bottoms have coincided with new monetary liquidity programs, and in the recent instance, the 7.5% drop in equity prices was stymied by buyers even before Bernanke reminded investors this past week that the economy needs the Fed's "highly accommodative monetary policy" for the foreseeable future." Please tell us something new.

Yes, investors are smart and they have learned well.

But is it worth knowing what all of us already know? When it comes to the markets, the answer is "usually not". Or to put it another way, just when investors catch on, the market changes the rules.

So what does this have to do with the Rydex asset data? The Rydex data is based upon real asset flows. It is not an investor opinion poll. By tracking the money, we get to see how these investors are placing their market bets. While the Rydex market timers represent a small segment of the investing world, their actions remain a useful window into the mindset of investors. As the indicator below this daily chart of the S&P Depository Receipts shows, these investors have been buying the recent dip aggressively.

The indicator looks at the ratio of bullish and leveraged investors to bearish and leveraged investors. Not only do we get to see what direction investors think the market will go - i.e., are you bullish or bearish? - but we also get to see how much conviction they have in that bet because they are using leverage. At present, there are over 4 times as many leveraged bulls as leveraged bears, and this is high.

Over the past year, when the Rydex Bullish and Leveraged to Bearish and Leveraged ratio exceeds a value of 4, the markets have tended to top out. The red dots on this daily chart of the SPY shows those times investors have gone all in betting bullishly and with leverage.

So what is the take away message? Like Pavlov's dogs, market participants have learned to adapt. Anecdotally, just when market participants have the game figured out, the rules change. Current behavior in the Rydex investor is consistent with this dynamic, and if recent past experience is any guide, investors will not be rewarded.


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