The ‘Smart’ and ‘Dumb’ Money

Herding is when many investors make the same choice based on observations of others, independent of their own knowledge. Markets do tend to have phases when one sentiment becomes dominant. These diversity breakdowns are consistent with booms (everyone acts bullish) and busts (everyone acts bearish).

To the best of my knowledge, there is no one barometer that accurately and consistently measures investor diversity. An objective assessment of public (media) and private opinion probably gives some good clues.

That’s what Michael Mauboussin, Legg Mason’s Chief Investment Strategist, wrote in his sure-to-be-investing-classic book, More Than You Know.

And it’s probably the best explanation of what’s going on in the markets today.

Now though, with the markets showing continued and exceptional strength, we have to wonder whether it’s time to take profits or let our winners ride. To do that, we’ll have to look at some of those “good clues.”

The “Smart” Money

There are all kinds of definitions for smart money. I consider the best tracking of smart money to be the American Association of Individual Investors [AAII] Investor Sentiment Survey.

The survey is made up of the individual market assessments of regular retail investors (like you and me) who are members of AAII. So it’s most likely skewed to investors who watch the markets fairly closely. So if you asked most of the participants in the survey, they’d consider themselves smart money.

Since the survey started, its findings have averaged 39% of investors are bullish, 30% bearish and 31% neutral. A slightly bullish leaning would seem about right for a market which goes up 11% per year over the very, very long run. But the survey results actually reveal a lot about this smart money.

In the first week of March, the AAII survey found bearishness hit an all-time high. Only 19% of investors were bullish and 70% were bearish. The markets went way up.

In mid-August, the survey found 51% of investors were bullish and 33% were bearish. The market went up.

At the end of August, the survey reported 34% of investors were bullish and 48% were bearish. The markets went up.

Last Friday the survey found only 37% of investor were bullish and 44% were bearish. The markets have since gone up.

See a pattern?

I hope so. In every one of these surveys bearish sentiment is above the long run average. Also, the market has gone up shortly afterwards every time.

That’s just a small sampling. They were all taken from a period when the markets only went up. But it gives you a pretty good idea that bullish sentiment is still far from a euphoric high.

The “Dumb” Money

That’s the “smart” money crowd though. There’s also the dumb money which, as you’ll see in a second, is a force to be reckoned with.

I consider the dumb money to be those investors who turn their investment dollars over to mutual fund managers. Now they’re not necessarily dumb people. But the idea of handing over the money to a group of managers who, as a group, failed to beat the markets and still have the gall to charge as much as 2% or 3% for their inadequate services is a pretty dumb move.

Lately, the dumb money has continued to plow money back into the markets.

Last month was an amazing month for the dumb money investors. Morningstar reports $54 billion of new cash was handed over to mutual fund managers.

The strong month brings the six month total mutual fund inflows for the year to $226 billion. That’s an astounding amount of money. And just proves the point, if you throw enough money into something, prices will rise.

This just feeds the bull. The markets are going up and they want in. And they want in big. The markets go up some more and they come rushing in for more.

As we’ve seen time and time again though, the dumb money buys and sells at the worst possible time. In the short-term they’re right. In the long-run, they’re almost always wrong.

One Rule about Calling Bottoms

In the end, the herd is made up of dumb money and smart money. The only real difference is the smart money gets out first.

The important thing here is that it still looks like the herd has not completely jumped on this bull…bear market rally…or whatever you want to call it. When they do, that’s when the herd will be in full force.

That’s why we could be in the early stages of a blow-off top for the markets – which you don’t want to miss – and there’s a rough down leg coming.

Or the economy could be in a true recovery. If you watch GDP numbers, it sure will appear to be. You have to remember though, simply selling a house adds to GDP, although no new wealth is created. So we may be in an official recovery as economic transactions increase, but it may never feel like it to most folks.

No one knows for sure. But we do know one thing. The smart and dumb money will move the markets in one direction. The odds of a flat, ho-hum 10% rise in the markets are low.

My best advice is, don’t fight the market, it will win. Go with it, and you will win.

That’s why I still recommend buying stocks and using trailing stop-losses. That way you’ll be there for a blow-off, “sugar-high” rally and you’ll know when the rally is over because your portfolio will be all cash.

Tomorrow we’ll look at the simplest way to profit from this market (a small group of folks just used it to make 73% in two weeks) for maximum safety and profit. It’s a different market, but the strategy we will go over is perfectly suited for these conditions.

By Andrew Mickey

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