Follow the Fed

The next meeting for the Federal Reserve is next week on June 17th- 18th. Fed Chairperson Janice Yellen may take advantage of a positive stock market and economic data to “talk tough,” as my friend Brooke Thackray recently called it, by committing herself to more restrictive action in the future. Should Ms. Yellen change her tone from her recent “dovish” language to “less-accommodative”,  this may stifle the recent stock market rally in mid-month.

While we await next weeks Fed speech, I note that my favorite sentiment composite, the “Smart vs. Dumb Money” spread, has widened. Below is a chart from sentimentrader.com (www.sentimentrader.com) . You will note that when the spread (very bottom pane)  widens above the red horizontal line and peaks, the market tends to exhibit near topping or topping action. This indicator has called short and longer termed corrections pretty well, although it was a bit early in 2011. 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. 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.

The spread is well into bearish territory, but it has yet to peak and hook back down. This is a danger signal. The Smart Money Confidence line (second from top, just below the S&P 500 chart—green line) is falling into bearish territory. The smart guys are not so excited about the market right now. Meanwhile, the Dumb Money confidence line – next pane below the smart guys, in red– is also in the danger zone.  Dumb money likes this market.

Perhaps next week’s Fed speech will inspire a bit of profit taking – the smart guys, according to this chart, have already started that process.