http://www.schaeffersresearch.com/commentary/observations.aspx?ID=97991&obspage=1

Indicator of the Week: The Nova/Ursa Ratio
By Rocky White, Senior Quantitative Analyst

Foreword:One indicator that we use at Schaeffer's to gauge sentiment is the Rydex Nova/Ursa ratio. Nova and Ursa are a couple of mutual funds offered by the Rydex Series Trust. The Nova fund is a leveraged fund designed to return 150% of the daily return of the S&P 500 Index (SPX). The Ursa fund is designed to return the inverse of the SPX. In short, Nova is a bullish fund and the Ursa is a bearish fund. The Nova/Ursa ratio compares the amount of assets in each fund. When this ratio is high it means there is a lot of money invested in the bullish Nova fund compared to the bearish Ursa fund. Therefore, it signals a lot of optimism in the market. On the contrary, a low Nova/Ursa ratio signals a lot of pessimism in the market.

Current Reading:From a contrarian perspective, the current reading on the Nova/Ursa ratio is very bullish, arriving at its lowest point since the middle of 2006. Below is a chart of the Nova/Ursa ratio alongside the SPX. The green dots mark points on the SPX when the Nova/Ursa ratio hit fresh one-year lows. Note that this ratio has trended lower during the past year, despite strong price action in the market. This high amount of pessimism represents plenty of sideline cash that can still flood into the market and reinvigorate this rally.

Historical Performance:As I often do, I looked back to see if this indicator has had any historical significance. In doing so, I considered it a "buy" signal every time the Nova/Ursa ratio hits an annual low. Furthermore, I considered only one signal every two months for data dating back to 1994, when we started collecting data on the ratio. The table below details returns following a "buy" signal.

As you can see from the table above, returns following a "buy" signal are quite bullish when compared to typical market returns since 1994. This is especially true at three and six months out. The average returns significantly outperform, despite being dragged down a bit by one particularly bad signal in late 2008 - which is why the median returns show even better performance than the average.

Implications:The Nova/Ursa ratio is showing pessimism at a multi-year extreme. Furthermore, the pessimism has been growing during the past year despite the strong price action of the market. Remember, this indicator is not a phone survey or investors checking boxes. It measures actual dollars being put at risk. I like what we're seeing from this indicator, as it tells me there is plenty of money on the sidelines to propel this market higher.