The Investment U E-Letter: Issue # 400
Monday, January 3, 2005

Smart Money Indicator: What the Dumb Money Is Doing Now and How to Profit From It
By Dr. Steve Sjuggerud, Advisory Panelist, Investment U

Dear Investment U Reader,

I found Jason Goepfert’s column over the weekend so informative, I asked him if we could share a portion of it with you. So here is your smart money indicator in a nutshell: the “dumb” money is extremely optimistic about stocks right now…

This is important now because, as Jason reminds us below, when the dumb money feels “strongly about a particular market direction, they have a consistent tendency to lose money.”

Read Jason’s weekend e-mail below. And once again, consider playing it extremely safe with your stocks over the next few weeks and months…

Steve

What The “Dumb” Money Is Doing Now
From www.SentimenTrader.com (Jan. 2, 2005)
by Jason Goepfert

In the 1990s, I had a firsthand look at the raw emotion that many investors exhibit with their investments. As the manager of operations for what became a relatively large discount brokerage, one of my responsibilities was overseeing the margin department.

By watching the flow of applications for margin and options accounts (particularly from those with no previous experience), I could see when the prospects of quick riches were overtaking careful analysis.

That experience came back to haunt me this past week, as I checked with some of my contacts still in the brokerage business. Applications for margin and option accounts are up several-fold from where they were a year and a half ago, and while they’re not seeing the wild-eyed excitement from years past, my contacts were busy trying to fulfill these accounts.

I’m not one to place too much emphasis on anecdotal evidence – I feel a lot more comfortable if I can put some reliable numbers down and look at historical patterns. With the beginning of the new year, it’s an excellent time to visit several measures that we follow that are based on real money. These are not traders’ opinions; they are not surveys, they are not guesses. Every measure discussed below is generated by looking at what traders are actually doing with their hard-earned capital.

Generally, we group traders into two categories – the “dumb” money and the “smart” money. I don’t particularly like either moniker, but they are colorful descriptions that help us to remember that we should bet against the “dumb” and bet with the “smart.”

So let’s take a look at a few measures that track the “dumb” money today (and one that tracks the “smart” money). And remember, these indicators are based on what traders are actually doing with their money.

First, the Dumb Money Indicator…

Bottom Line: They are long and getting longer.

Our first measure is the R.O.B.O. put/call ratio. This indicator looks only at the very smallest of options traders – those who trade 10 contracts or less at a time. We further restrict the indicator to look only at those transactions that are being bought to open.

Unlike traditional put/call ratios you may see elsewhere, with this measure we get to see exactly who is doing exactly what. When these small traders (the average transaction size here is between $200 and $2,000) trading these highly leveraged instruments feel strongly about a particular market direction, they have a consistent tendency to lose money.

For the latest week, the ROBO put/call ratio closed at 0.33. We can flip that ratio around and discover that these smallest of traders are buying three times as many calls as they are puts.

This type of unbridled enthusiasm from this type of trader has only been exceeded once since the bubble days of 2000, and that was near the top last January. When small traders feel so little need to protect themselves (or speculate) on a move lower in the market, that’s when I prefer to look for one.

Now, let’s look at the traders who frequent the Rydex mutual fund family. I know a lot of very sharp investors who use these funds, so it’s difficult to describe them as “dumb.” But whenever a bunch of people are leaning the same way, we start to see some group-think develop, and when there are too many rushing to one side of the boat, it has a tendency to capsize.

My preference with this fund family is to look at the total dollar amount of assets in the leveraged funds only. These funds move $2 for every $1 the underlying indexes move, and from my experience as the manager of a margin department, I know for a fact that people behave differently when they are leveraged.

In the chart below, the green line represents the total dollar value of leveraged assets in the S&P 500 and Nasdaq 100 bull funds (that rise when the market rises) and the red line is the total assets in the leveraged bear funds (that rise when the market falls).

Since September 23, the S&P 500 has gained 9%. Impressed by the rally, traders have poured so much money into the leveraged bull funds that the assets have risen by 64%. While some of that is new money, and some more of it came from the money market, most of it appeared to come from the leveraged bear funds, which have seen their assets cut in half during this time.

These traders are not betting to a large degree on a move down in the market, and they are not hiding in the money market (whose assets as a percentage of the total are now lower than at any time since 2001). They are betting heavily on a further rally, and it looks like this boat is becoming awfully crowded.

The last dumb money indicator we will look at today is our Odd Lot Purchase Percentage. An odd lot trade is one that is executed for fewer than 100 shares, and is generally considered to be a reflection of small-trader sentiment. The money indicator simply looks at the number of shares these traders buy on a given day as a percentage of total odd lot volume. The higher the indicator, the more these small traders are buying.

Over the past two months, these traders have concentrated about 55% of their orders on the buy side. This is one of the highest percentages in recent history – exceeded only by late 2000/early 2001 when they were buying hand-over-fist in anticipation of a resumption of the good times that had just ended. Another time that approached the current one in terms of the amount these traders were buying was June 1992, after which the S&P struggled in a trading range for four more months.

The Smart Money Indicator

Bottom Line: A potentially vicious cycle is in place.

Total assets at fund firms are approaching all-time highs (see chart), while the percentage of their assets held in liquid instruments like cash is scraping along near all-time lows.

If cash levels are low, and investors begin to redeem an increasing number of shares at these funds, then how can the managers meet the redemptions? By selling. It is a vicious cycle, because that selling will push prices down, which will cause more redemptions, which will cause more selling.

In sum, the dumb money is overly optimistic and the smart money indicator is in a dangerous and potentially vicious place. Based on this, my trading stance for the coming weeks (and likely months) should be no surprise:

We are modestly short in the SentimenTrader.com model portfolio, and looking to increase that position.

Jason Goepfert

Good investing,

Steve

Today’s Investment U Cribsheet

• When the dumb money’s all flowing in the same direction, chances are, these folks can give you all the reasons they’re doing it. For some examples of what reasons you DON’T want to make an investment, read IU E-Letter #346 – The Dirty Words of Investing.

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