The S&P 500 has been in a pattern that is considered bearish by some market observers. This pattern plays off of an old theory suggesting that “dumb money” trades in the morning, while “smart money” trades in the afternoon.
Here is how it works:
Dumb money is thought to move in the morning. Retail investors trade in reaction to recent news events or sentiment. They are reacting to very recent or even old news – myopically. Their knee-jerk trades can create sharp price movements in one direction. The first hour or so tends to to be the most volatile period, providing plenty of sophisticated day traders to take advantage of this movement. Program trading reacts quickly to breaks in various moving averages on an intraday basis – adding to the fun. Although it sounds harsh, professional traders often know that a lot of “dumb money” is flowing at this time. So do the program traders.
Smart money is thought to move the later part of the trading day. Stocks are ready to be scooped up by the pro’s on the fear trade of earlier hours, or sold by the pro’s based on knee-jerk bullishness. Theoretically, the selling pressure in the afternoon can be more significant as a predictive indicator than buying pressure in the afternoon. That’s because of the longer termed bullish bias of stock markets to go up. Selling indicates a more unusual conviction by the smart money than does buying.
Ok, now lets look at the more traditional smart/dumb money indicator. The best out there is published by sentimentrader.com. I use this indicator in my Bear-o-meter risk/reward compilation. Here is my last reading of the Bear-o-meter. The smart/dumb indicator pits the most successful investors (smart money) against the least successful investors (dumb money) in a quantitative model.
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 sentimentrader chart below shows us how the smart money – the blue line – isn’t very bullish at this point. Meanwhile, dumb money – the red line – is “Lovin’ every minute of it”. Just like the song from Loverboy
Note how when the blue line drops below its horizontal trigger line while the red line (dummies) climbs into a high-confidence level – coincidingly – markets tend to react in the favor of the smart money. They often sell off if smarties are worried and dummies are singing the Loverboy song. That’s where we are now.
Dumb money is buying in the morning and smart money is happily selling to them. The dumb guys are confident with that decision to buy while the smart guys are net bearish, according to the sentimentrader chart. Both of these indicators might give us pause before we commit to buying new stocks at this time.
As Forest Gump once said: