Smart money / Dumb money confidence spread is something that www.sentimentrader.com tracks. “Smart” investors are those who tend to make better buy/sell decisions at market extremes. They include large sophisticated institutions like pensions and commercial hedgers, insiders and other better informed investors. “Dumb” investors, according to this study, are those who reach the highest levels of confidence at inopportune key market turning points—that is, they are most bullish at tops and most bearish at bottoms. Dumb money includes unsophisticated investors – the indicator focuses on retail mutual fund investor moneyflow (in and out of equity funds), small traders, and small speculators. Subscribers to sentimentrader can watch each group independently, or as a spread. The formula to calculate the confidence spread (differential) is:
Smart money % confidence level – Dumb money % confidence level = confidence spread.
A spread reading of below -0.25 implies not enough confidence by the smarties. It also implies the dummies are buying stocks hand over fist. This is the level where sentimentrader suggests we pay close attention, as the potential for a market top is increasing. The current level of Smart/Dumb confidence spread sits well below the minimum warning level suggested by sentimentrader – as at April 25th, the spread sat at -0.50.
I’ve drawn arrows on the chart above showing similar occurrences- that is, when the spread approached -0.5 or so. You can see it has been as often a leading indicator as it has been a coincident indicator. A long gap occurred after a 1st quarter signal in 2015, where markets didn’t correct until the 3rd quarter of that year. This was one of the signals that inspired me to raise cash last March- but it was a long wait before that move was proven prudent. Also note the two circled zones – which indicate that the spread was unfavorable through much of 2009 and 2013. Both of those years saw strong bull trends. So, as with most indicators, this one should not be used alone or thought of as the panacea of market timing indicators. It can be wrong. Its track record is, however, good enough to pay close attention to in conjunction with other indicators.
Combining the Smart/Dumb confidence spread with pending seasonal weakness, potentially expensive valuations and pending overhead technical resistance (2135), the market may be presenting unfavorable risk vs. return potential right now. As Technical Analysts, we don’t time the markets – we simply measure potential risk vs. potential return. Remember, risk and return are always present—stocks can go up in a high risk environment. Stocks can fall in a low risk scenario. We’re only dealing with odds – not with absolutes. I might suggest that the odds are less favorable for greater upside in the coming weeks, while the odds for a retracement to the January lows, or lower, are becoming more favorable. That said, anything can happen.