You’ve probably heard a lot about so called “dumb money” and “smart money” but what does this mean? Can money really be dumb or smart? I’m pretty sure we’ve all been the dumb money before. For example when I spend $16 for a drink at a Miami Heat game that would probably be a good example of being the “dumb money” or people who spend more than the price of a beachfront condo on a new car might be considered to be dumb money:
However, at some point these people likely had to be the “smart money” in order to become the dumb money at a later date. In financial markets there are a panoply of smart/dumb money indicators which in theory are supposed to help market participants figure out what they should and/or should not be doing. These “indicators” all have one guiding principle in common:
Institutional money (big money) = smart – retail money (small money) = dumb.
In theory this makes a lot of sense – large institutions such as hedge funds and pension funds have vast resources with which to obtain information which should give them an edge over other market participants. Moreover, their sheer size alone can help to move markets. For example, if I knew that CALPERS was planning to allocate an additional $1 billion to small cap growth stocks ($IWO) I would probably want to be long small cap growth stocks before they bought in. But would I want to buy these stocks after CALPERS bought in?
Another problem with smart money indicators is that large institutions tend to exhibit a strong tendency toward herd behavior – they tend to get defensively/aggressively positioned at the same times. A perfect example of this phenomenon occurred at the market bottom in early October – most portfolio managers had moved to heavily overweight cash positions and some were even leaning short as the $SPX toiled around in the low 1100s. The chart below of NAAIM active manager sentiment helps to illustrate just how bearish the smart money was positioned at the October market low:
On October 5th, 2011 the NAAIM survey registered its lowest sentiment reading since its inception (even lower than October 2008) – in hindsight this was a powerful indication that a market bottom was close at hand. Another so called smart money indicator is the CBOE index put/call ratio. The theory is that institutional money mangers will hedge with index puts at or near market tops – let’s take a look at how well this indicator has worked recently:
I don’t see any edge at all in this smart money indicator, in fact it looks like the index put/call ratio was abnormally high (1.40 is about average) at key market bottoms. The mid-October reading of 2.03 came more than one week and 70 S&P points before the October 27th top; therefore, money managers were heavily hedged as the market was about to launch another 5%+ higher. It doesn’t look like this money is quite as smart as it has been made out to be.
The point of showing the NAAIM survey chart and the index put/call ratio chart is to demonstrate that very often big money doesn’t necessarily mean smart money. All too often large portfolio managers make decisions out of fear and greed just like a retail investor might. Moreover, a portfolio manager running $5 billion is also likely to have a much different incentive structure and different motivations which will prevent optimal decision making in the markets.
Some of the favorite “dumb money” indicators are the sentiment surveys such as the AAII survey, Investor’s Intelligence, and Market Vane. Once again the theory behind these dumb money indicators is that the dumb money will tend to get bullish at market tops and bearish at market bottoms. The problem with this theory is that during strong market trends dumb money sentiment can remain right a lot longer than your “smart money” can remain solvent trying to fade them – take a look:
AAII bullish sentiment has remained above its historical average as equity markets have soared to multi-year highs in 2012. Moreover, the Market Vane bullish sentiment on the NASDAQ-100 ($QQQ) has hovered between 75-80 (highest bullish sentiment of any major market) for the last several weeks as the large cap tech index has continued to make higher highs.
Eventually the dumb money will get it wrong and overstay the party, however, the point is that the usefulness of these dumb/smart money indicators is heavily overstated particularly in trending market environments. In fact, I will go as far as to state that market participants who rely too heavily on sentiment surveys, put/call ratios, etc. turn themselves into the dumb money.
In summary, financial markets are all about performance and results – In other words the dumb money can turn into the smart money and vice versa depending upon market outcomes. It is much more important to know how the herd is positioned and more importantly when/where it will move next than to focus on dumb/smart money indicators which have proven to be relatively ineffective in recent history.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
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This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice.This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities.
In partnership with Part of the CNN Network
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