In the stock market, money moves from the weak players (dumb money) to the strong players (smart money). It’s actually a negative sum game since brokerages and exchanges take fees and commissions off the top as the money exchanges hands. In order for winners to win, someone must lose. So… are you dumb money?
No one wants to admit it but we’ve probably all been dumb money at some point. I know I certainly have. Through study, practice, wins, and losses, I have learned to make better and better investment decisions over time. After all, investing is a game of percentages so the goal is to make higher percentage (smart money) decisions.
Dumb Money / Smart Money
Jason Goepfert of sentimenTrader publishes a Smart Money / Dumb Money Confidence Level chart, a fantastic indicator to keep in touch with the pulse of the market. As Benjamin Graham described, Mr. Market is a manic depressive who shifts from moods of wild optimism to extreme pessimism. By understanding what mood Mr. Market is in, you can make better investment decisions.
Here are the Dumb Money and Smart Money Confidence Levels at the outset of the week:
Dumb Money Confidence Level: 71%
Smart Money Confidence Level: 19%
When there are extreme spreads (about 50%) between the two levels, this tells us that Mr. Market is in one of his wild moods. Right now he is excessively optimistic. In other words, buying right now is buying high.
You can see in the chart above (click to enlarge) the few instances in the past year when Mr. Market has gotten into one of his moods. A year ago he was very pessimistic which is when there was an extreme spread in favor of the Smart Money Confidence Level. It proved to be a great buying opportunity.
Now we have entered the third instance of Mr. Market reaching a level of mania. These levels do not mean that the market is going to crash, but they do show that upside is very limited. Along with bearish divergences of the powerful MACD indicator (marked with red arrows), they signal an intermediate term correction is highly probable. In the two previous occasions, you can see the market moved lower before reaching new highs. The latecomers to the party are likely to get spooked before the party can continue on.
We are in a bull market, so higher prices are likely in the long-term. But in the intermediate term we should see some corrective action. This is where the supply of stock moves from the weak hands to the strong hands.
So what should you do?
You can either stay calm and hold through the correction or get out to reposition yourself. Personally, I do a little bit of both. Our retirement accounts are for the long-term, but in other accounts I’ve shifted my position to mostly cash.
Most importantly, if you’re planning to put new money into the market — wait. That’s a dumb money move.
Featured Image Courtesy of efile.com.