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Sentiment Reaching Scary Extremes in US Stock Market: Time to Get Defensive

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We haven't see this much bullishness since the height of the dot-com bubble.

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Fear and greed -- the two emotions that dominate the stock market. In 2008, as he was buying stocks during the depths of the financial crisis, Warren Buffett famously said that you want to be greedy when others are fearful.

Of course the truth works the other way as well. You want to be fearful when others are greedy. The recent market action has me worried. I was a raging bull in early 2009 when the S&P 500 (INDEXSP:.INX) was bottoming. However, I began to taper this bullishness in 2012, turning neutral in 2013 (hey, no one is perfect), and have become extremely bearish on the S&P and Nasdaq (INDEXNASDAQ:.IXIC) as we enter 2014.

Let me give you examples of two indicators that scare the heck out of me at the moment.

1. Investors Intelligence
This is a poll of professional investors. History shows they are about as smart, errr dumb, as the rest of us. Even the pros tend to get bearish at bottoms and bullish at tops.

Investors Intelligence measures three types of sentiment -- bullishness, bearishness, and neutral. I throw the neutrals out as they do not have a concrete position. To make things simple, we will look at the ratio of the bulls and bears as a gauge for how bullish investors are. Recently we had a scary situation in which the bullish readings were at nearly 2.5-year highs and the bearish readings were at, yikes, 1999 lows! Yes, low readings not seen since the height of the dot-bomb bubble top. The ratio of bulls to bears was over four bulls for every bear, something that has not happened since August 1987. I seem to remember something happened to the stock market during the fall of 1987. The ratio is higher than the 2007 stock market peak.

2. The Rydex Ratio
The Rydex group of funds are funds that investors can choose to long and short the market with. They also have money market funds. The Rydex Ratio is calculated by taking the number of people invested in short money market funds and dividing them into the number of assets that are in long funds. This fund typically trades in the .070 range, meaning there are usually about $1.40 in every bull market fund for about $1.00 in every bear and money market fund. It tends to call market tops when the ratio goes under $0.50 (meaning more than $2 in bull funds for one in bear and money market funds) and market bottoms when it goes over $2 (meaning $0.50 in bull funds as opposed to $2.00 in money market and bear funds).

This ratio is now 0.25, the lowest reading since 2000, the height of the secular bull market and dot-com bubble.

The holidays are a time for fun and cheer. However, they are also a time for reflection. As we look at the frothiness of this stock market, it might be time for investors to begin to look at ProShares UltraPro Short S&P 500 ETF (NYSEARCA:SPXU) or the Nasdaq Short ETF ProShares Trust UltraPro Short QQQ ETF (NASDAQ:SQQQ).

From the above we can see sentiment is not only overly bullish, it is at very dangerous extremes. Topping is a process, and the market probably won't crash overnight, however, now is the time to get defensive.
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