SMART MONEY AND DUMB MONEY CONFIDENCE INDICES

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APPLICABLE TIME FRAME(S):  

INTERMEDIATE-TERM (ONE TO THREE MONTHS)

 

UPDATE SCHEDULE:

Each weekday night by 7:00 PM EST

 

EXPLANATION:

The Smart Money Confidence and Dumb Money Confidence indices are a unique innovation that allows subscribers to see, in one quick glance, what the “good” market timers are doing with their money compared to what the “bad” market timers are doing. 

Our Confidence indices use mostly real-money gauges – there are few opinions involved here.

Generally, we want to follow the Smart Money traders when they reach an extreme – we want to bet on a market rally when they are confident of rising prices, and we want to be short (or in cash) when they are expecting a market decline.  We also call this measure the "Buy Confidence" indicator - it tells us how much confidence we should have in buying the market.  The higher the confidence number, the more aggressively we should be looking for higher prices.

Examples of some Smart Money indicators include the OEX put/call and open interest ratios, commercial hedger positions in the equity index futures, and the current relationship between stocks and bonds.

In contrast to the Smart Money, we want to do the opposite of what the Dumb Money is doing when they are at an extreme.  These traders have proven themselves over history to be bad at market timing.  They get very bullish after a market rally, and bearish after a market fall.  By the time the majority of them catch on to a trend, it’s too late – the trend is about to reverse.  That's why we call this the "Sell Confidence" indicator too, as it tells us how confident we should be in selling the market. 

Examples of some Dumb Money indicators include the equity-only put/call ratio, the flow into and out of the Rydex series of index mutual funds, and small speculators in equity index futures contracts.

We also chart the spread between the Smart Money and Dumb Money.  This gives us a quick view of the difference between the two groups of traders.  Because the "dumb money" follows trends, and the "smart money" generally goes against trends, the "dumb money" is usually correct during the meat of the trend.  So when the Dumb Money Confidence is higher than the Smart Money Confidence, that means sentiment is positive.

When it becomes too positive, however, then sentiment has reached an extreme, and stocks often run into trouble.  This usually happens because the Dumb Money rises above 60%, and the Smart Money drops below 40%.  That is a warning sign for stocks.

When the Dumb Money is below the Smart Money, then sentiment is negative and stocks are usually struggling.  It's best to be defensive at times like this.  However, when sentiment becomes too negative, then stocks are often poised to rally over the next 1-3 months.  This usually occurs because the Dumb Money has dropped below 40% and the Smart Money has risen above 60%.

The whole concept of "smart" and "dumb" money is controversial, and we spent a good deal of time thinking about whether we wanted to call it that before we did.  Bottom line, it's quick and easy to remember, and that was the point in naming it that way.

What is considered "smart" is simply based on an indicator's historical record at extremes.  If an indicator is usually showing excessive pessimism near a market peak, and excessive optimism near a
market bottom, then that indicator will be included in our Smart Money calculation.  And if it consistently shows too much pessimism near a low and too much optimism near a high, it will be considered Dumb
Money.

This is where it gets controversial - most "smart" investors are lumped into the Dumb Money category.  A decent example is the Barron's Big Money poll.  That's not part of our calculation, but it demonstrates the concept.  Individually, that's a very sharp group of investors.  But when they reach an extreme in sentiment one way or the other as a group, then it's often best to look the other way.  Same goes for active investment managers.  And institutional traders.

The other controversial part is that the Dumb Money is almost always right during the meat of a trend.  And the Smart Money is almost always going against it.  But that's not the point of our service -
our goal is to highlight the extremes in sentiment.  So even while the Dumb Money is usually right during the trend, when they become extreme the market consistently turns.

GUIDELINES:

Our Confidence indices are presented on a scale of 0% to 100%.  When the Smart Money Confidence is at 100%, it means that those most correct on market direction are 100% confident of a rising market…and we want to be right alongside them.  When it is at 0%, it means that these good market timers are 0% confident in a rally, and we want to be in cash or even short when confidence is very low. 

We can use the Dumb Money Confidence in a similar, but opposite, manner.  For example, if the Dumb Money Confidence is at 100%, then that means that these bad market timers are supremely confident in a market rally.  And history suggests that when these traders are confident, we should be very, very worried that the market is about to decline.  When the Dumb Money Confidence is at 0%, then from a contrary perspective we should be concentrating on the long side, expecting these traders to be wrong again and the market to rally. 

In practice, our Confidence Indexes rarely get below 30% or above 70%.  Usually, they stay between 40% and 60%.  When they move outside of those bands, it’s time to pay attention! 

Let’s look at a few real-world examples to see the Confidence Indexes in action. 

First, we’ll look at late 2004 and early 2005 to see how the Confidence Indexes behaved during those market moves.

In early and late December 2004, the chart above shows us that our Smart Money Confidence dipped below 40%, telling us that the good market timers we follow were not very optimistic that the market would keep rallying.

At the same time, the Dumb Money Confidence was extremely high – nearly 70%.  That was a big warning sign – it was time to become very defensive with our portfolios by selling out what stock we were holding, or buying put options to protect ourselves from a probable impending market decline.  For the more adventurous among us, it was a good time to brush up on our short-selling skills to possibly profit from a fall.

By mid-April, things were looking better.  By now, the Smart Money was more optimistic, but the Dumb Money was stubbornly bullish until then.  Now that the Smart Money was more than 60% confident of a rally, and the Dumb Money was less than 40% confident, it was time for us to become fully invested once again, or even buy call options (or sell put options), to profit on what was likely going to be a market rally. 

Let’s zoom out a bit and look over a longer period of time.  The chart below covers the period from early 2003 through mid-2004. 

The spring of 2003 was a time when our Smart Money was quite confident of a rally, while the Dumb Money dropped down to nearly 20% - a very extreme reading of excessive pessimism from poor market timers.  Not surprisingly, the market took off on one of the most impressive rallies in history. 

By June 2003, however, these guys caught on to the rally and became more confident that it would continue.  But notice that our Smart Money never really turned bearish – they were still pretty confident that the market would continue higher.  When we see such a thing, we should expect the market to consolidate – not really going much of anywhere while the two sides battle it out. 

By early 2004, it was time to become defensive.  The Smart Money Confidence dropped down to 40% while the Dumb Money Confidence was extremely high at 80%, always a recipe for trouble.  But by March and May, we once again saw “buy” signals, as the two groups became much more in line with what we should expect to see near market low points. 

Over the past 20 years, we’ve been able to see our Smart Money and Dumb Money Confidence Indexes perform through a challenging variety of market conditions. 

The table below shows how the S&P 500 index performed 90 days after “buy signals” and “sell signals”.  For these purposes, we’ll consider a buy signal to be any time the Smart Money Confidence was above 60% at the same time the Dumb Money Confidence was below 40%.

A sell signal will be any time the Smart Money Confidence is below 40% at the same time the Dumb Money Confidence is above 60%. 

 

BUY SIGNALS

SELL SIGNALS

Percentage of time the S&P 500 was positive

75%

40%

Average Return(annualized)

+11%

-8%

For those with shorter time frames, the Confidence Indexes can be useful too.  When they are on a “sell” signal, you want to be more aggressive in taking short setups from your methodology – either taking more of them, or using bigger position sizes when you do.  But when the Confidence Indexes are on a buy signal, you want to be particularly aggressive in taking long-side setups or upping your position sizes on long positions.  By following that strategy, you should improve your odds of a profitable trade and enjoy a bigger average winning trade. 

Our Confidence Indexes are updated each evening, with links to the current chart and that day’s readings on the Daily Overview and Indicators pages.  We hope that following these traders’ money movements will help you adjust your own trading, and benefit your bottom line. 

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