Should We be Worried about ‘Smart Money’ Leaving Stocks?

Uh-oh. The ‘smart money’ is selling stocks. It rarely pays to bet against the smart money, which includes insiders and hedgers with deep pockets and big research budgets. Should we be worried about their stock market exodus?

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness.”

Charles Dickens classic novel “A Tale of Two Cities” describes London and Paris during the French Revolution, but it could also be applied to Wall Street post 2009.

It is the ‘best of times’ as the S&P 500 (NYSEArca: SPY), Dow Jones (NYSEArca: DIA) and Russell 2000 (NYSEArca: IWM) move from one all-time high to the next. Even the Nasdaaq (Nasdaq: QQQ) is within striking distance of its all-time high.

It is also the ‘worst of times’ for many permabears, who continue to trash talk every rally … and get crushed.

Some of you may remember my inflammatory message for stock market bears published in the July 13, 2014 Profit Radar Report:

Here’s a message for everyone vying to be the next Roubini: A watched pot doesn’t boil and a watched bubble doesn’t burst. The stock market is not yet displaying the classic warning signs of a major top. There will be a correction, but the bull market won’t be over until most bears turn into bulls or the media stops listening to crash prophets.”

My bullish conviction was rooted primarily in extreme investor pessimism (reflected by the following July 2013 headlines) and the absence of the one ingredient that foreshadowed the 1987, 2000 and 2007 crashes (more details here).

  • MarketWatch: “If ever there were a time for a stock sell signal, it’s now”
  • CNBC: “Market will crash, just don’t know catalyst: Faber”
  • Reuters: “Billionaire activist Carl Icahn says ‘time to be cautious’ on U.S. stocks?”
  • CNBC: “I’m selling 6 times more than buying: Wilbur Ross”

Today, we are back at (or near) all-time highs and read headlines such as: “Why the smart money is bailing out of the bull market.”

Indeed, the ‘smart money’ is selling stocks as the ‘dumb money’ is rushing in.

Is this bearish? If so, how bearish is it?

Here is a look at six different sentiment gauges consistently tracked by the Profit Radar Report.

Of the six Profit Radar Report staples only four show extreme optimism:

Newsletter writers polled by Investors Intelligence (II) are the most bullish since June 2014 and active investment managers (polled by NAAIM) haven’t been as bullish since November 2013.

The VIX is low, but needs to shed another 20% before reaching last year’s extreme.

The CBOE equity put/call ratio and CBOE SKEW are only in midly bearish territory.

The media seems somewhat suspicious of new highs, but not nearly as bearish as in June/July 2014.

To be fair, a number of ancillary sentiment gauges match the kind of sentiment extremes seen in December 2010 and 2013.

My interpretation is that current gains will soon be given back, but any correction now or in the near future is likely to be followed by new recovery highs later on.

What’s the benefit of following the above six sentiment gauges?

Here is a more detailed track record published in the the December 2014 Sentiment Picture (the biggest reason to worry about stocks right now is listed at the bottom of this article):

Throughout 2014 many analysts, market timers, the media and ‘experts’ opined that the bull market is on borrowed time, largely because investor sentiment has been extremely bullish. Here are two examples:

  • Title: The boys who cried wolf: Crash prophets on the rise – Yahoo on May 2:

    Article excerpt: “The Dow Jones closed at an all-time high, which doesn’t change the views of the collection of Cassandras calling for a stock market crash. This group, including esteemed figures like Jeremy Grantham and Marc Faber have been emerging from their bomb shelters with relative frequency over the last month to reiterate their bearish views and insist they weren’t wrong with earlier calls, just early.”

  • Title: If ever the stock market flashed a ‘sell’ signal, it’s now – MarketWatch on July 9

    Article excerpt: “Sentiment indicators such as Investors Intelligence are at historic highs (that is bearish), and the RSI Wilder indicator is telling us the market is seriously overbought. Yes, the market can still go higher, but it’s on borrowed time. Don’t believe me? When you are standing 17,000 points in the air at the top of Dow Mountain, and the market is priced for perfection, there is nowhere to go but down.”

This widespread display of pessimism has been baffling and unfounded based on our set of sentiment gauges. At no point in 2014 did optimism reach levels suggestive of a major top. As the small selection of recent Sentiment Picture observations shows, an objective and in depth analysis of investor sentiment has persistently pointed to higher prices.

November 30 Sentiment Picture: “Investor sentiment is not at the kind of extremes usually associated with major market tops. Seasonality may draw prices lower temporarily, but the majority of sentiment gauges point towards higher prices later this year and/or early next year.”

October 31 Sentiment Picture: “In short, investor sentiment allows for further up side.”

September 25 Sentiment Picture: “Few sentiment gauges were at extremes on September 19, when the Dow Jones, S&P 500 and Nasdaq reached their new highs. If this selloff is commensurate to the lack of sentiment extremes at the actual high, it should be on the shallow side.”

August 29 Sentiment Picture: “The overall sentiment picture is fractured, and void of the ‘all in’ mentality seen near major market tops. Isolated extremes cause only small pullbacks here or there.”

The December Sentiment Picture shows a small up tick in ‘dumb money confidence’ (AAII, NAAIM) and complacency by option traders (CBOE Equity Put/Call Ratio). The CBOE SKEW is elevated.

Those readings could contribute to a pullback, but optimism is not pronounced enough to be indicative of a major top.”

The Biggest Reason to Worry about Stocks Right Now

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013 and 17.59% in 2014.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

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The ‘Smart Dumb Money’ is Market-Top-Worthy Bullish

Stocks caught a decent bid on strong breadth on Monday, but one accurate ‘dumb money’ indicator hit bullish extremes not seen since early 2011. This is a serious red flag as the featured chart clearly shows.

I always follow multiple indicators, especially when we’ve got ‘skin in the game.’

As per the August 28 Profit Radar Report, we went long the S&P 500 at 1,642.

Our up side target was an open chart gap at S&P 1,685. Open gaps pull price like a magnet. The S&P 500 is within striking distance of the open gap, and according to option traders risk is rising.

On Tuesday the CBOE Equity Put/Call Ratio dropped to 0.45, the lowest reading since early 2011 (blue line). This means that option traders are buying more than two calls for every put, a bullish extreme.

The 10-day SMA for the put/call ratio is at 0.566, the lowest since the May 2012 high.

What does such a low equity put/call ratio mean? 

Back in April 2010 the put/call ratio fell as low as 0.32 and I sent out the following warning and explanation to subscribers on record:

“The put/call ratio can have far reaching consequences. Protective put-buying provides a safety net for investors. If prices fall, the value of put options increases balancing any losses incurred by the portfolio. Put-protected positions do not have to be sold to curb losses. At current levels however, it seems that only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors get afraid of incurring losses, the only option is to sell. Selling results in more selling. This negative feedback loop usually results in rapidly falling prices.”

Just a couple of weeks later the S&P 500 (SNP: ^GSPC), Nasdaq, and Dow Jones spiraled lower in what was later dubbed the ‘Flash Crash.’

Obviously, the current reading is not as bad as in April 2010, but as the chart below shows it is at a level that’s led to lower prices all but once (with or without delay) since 2011. The one exception occurred in January 2012.

What to Do?

The Nasdaq (Nasdaq: QQQ) has rallied to new highs. This seems bullish, but seasonality for AAPL is soon turning bearish. The S&P’s up side target for the rally from the August 28 low – 1,627 for the S&P 500, 163 for SPY (NYSEArca: SPY) – is just a few points away. In short, risk is rising.

This doesn’t mean that prices can’t move any higher, but it’s prudent to lock in gains or raise stop-loss levels.

A stunning long-term outlook that puts the current rally into context is available to subscribers of the Profit Radar Report.

Simon Maierhofer is the publisher of the Profit Radar Report.

Follow Simon on Twitter at iSPYETF

Is a Market Top Near? ‘Smart’ Option Traders Send a Curious Message

Option trader sentiment extremes have racked up a fairly impressive track record as a contrarian indicator in the Fed’s QE bull market. No one else is talking about a major market top, so now might be an appropriate time to ‘check in’ with option traders and see what they have to say.

The QE bull market is 53 months old. The S&P 500 trades 156% higher today than at its March 2009 low, the Nasdaq-100 and Russell 2000 are up 209%.

No one else in the mainstream media is calling for a top, which is all the more reason to open this particular can of worms: Is a market top near?

One specific segment of traders has offered valuable clues about approaching market tops in the past: Option traders.

Equity Put/Call Ratio

The Equity Put/Call Ratio and SKEW Index capture the actions of the kind of option traders considered ‘dumb money’ (please don’t shoot the messenger, I didn’t come up with the term).

The Equity Put/Call Ratio shows the put volume relative to call volume. A ratio above 1 occurs when put volume exceeds call volume. The ratio is below 1 when call volume exceeds put volume.

Puts are bought to protect portfolios against declines; calls are bought as a bet on higher prices.

Since this is a contrarian indicator, high readings (0.9 or above) are usually seen near market bottoms when fear of a decline runs high. Readings around or below 0.5 reflect a dangerous extent of complacency and occur near market highs.

Last week the Put/Call Ratio fell as low as 0.55%. What does that mean?

The chart below plots the S&P 500 (NYSEArca: SPY) against the equity Put/Call Ratio (bottom of chart) and the SKEW Index (more about the SKEW in a moment).

The vertical red lines highlight readings at market tops.

When viewed in the context, the current Equity Put/Call Ratio is approaching a level that’s caused trouble for stocks in the past.
This note, which I sent to subscribers on April 16, 2010 explains exactly why: “The put/call ratio can have far reaching consequences. Protective put-buying provides a safety net for investors. If prices fall, the value of put options increases balancing any losses accrued by the portfolio. Put-protected positions do not have to be sold to curb losses. At current levels however, it seems that only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling results in more selling. This negative feedback loop usually results in rapidly falling prices.
This note preceded the 2010 ‘Flash Crash’ by only 13 days.
The current reading doesn’t foreshadow a Flash Crash, but a degree of caution is warranted.
SKEW Index
Like the VIX, the SKEW is calculated by the CBOE. The SKEW is far less popular than the VIX, but has delivered much better signals than the VIX lately.
The SKEW Index in essence estimates the probability of a large decline. Readings of 135 suggest a 12% chance of a decline. Readings of 115 suggest a 6% chance of a large decline (large decline is defined as a two standard deviation move).
In other words, low extremes are bullish for stocks; high extremes are bearish for stocks.
As the chart shows, the SKEW is currently in ‘bullish for stocks’ territory.
This contradicts the more or less bearish message of the Equity Put/Call Ratio.
What do we make of this?
Past experience has taught me not to bet against the SKEW. It’s prudent to allow for higher prices, perhaps after a shallow correction.
To get the best possible read on the stock market, I look at sentiment (such as options data and other sentiment/money flow gauges, seasonality and technical signals.
Right now the technical picture for the Nasdaq-100 (Nasdaq: QQQ) is fairly crisp and clear. The Nasdaq-100 is moving towards serious resistance in a well-defined trend line channel. This resistance increases the odds of a sizeable top dramatically.
Simon Maierhofer is the publisher of the Profit Radar Report.
Follow Simon on Twitter @ iSPYETF

 

S&P 500 vs. Investors – Are Retail Investors Really the “Dumb Money?”

Retail investors have many choices to buy and sell stocks: Mutual funds and ETFs are just two of them. Regardless of the options, investors are often considered the “dumb money.” Is the dumb money really dumb?

Wall Street geniuses and the financial media often consider retail investors the “dumb money.” That’s ironic, because Wall Street and the media are notorious for dishing out group think advice that’s getting many of the small guys burned.

There’s plenty of data that shows that a plain index investing or index ETF investing approach (the real “dumb” buy and hold a basket of stocks approach) handily beats the returns achieved by Ivy League educated mutual fund managers that engage in actively buying and selling.

If you’ve read my articles before you know that I like to pick on Wall Street and the financial media, but today we’ll talk about the investing prowess of retail investors – the “dumb money.” Is the dumb money really dumb?

Is the Dumb Money Really Dumb?

One of the best measures of retail investor’s appetite for stock is the asset allocation poll conducted by the American Association for Individual Investors (AAII).

The chart below plots the S&P 500 Index (SPY) against investors’ portfolio allocation to stocks. Investors’ stock allocation pretty much waxes and wanes with the performance of the S&P and almost plots a mirror image of the S&P.

Unfortunately, the cliché is true; retail investors buy when stocks are high and sell when stocks are low. I believe this is due to crowd behavior and the forces of investing peer pressure rather than stupidity, as the term dumb money implies.

What else can we learn from this chart aside from the fact that retail investors tend to buy high and sell low?

The average allocation to stocks since the inception of the survey in 1987 is 60.9% (dashed red line). The S&P currently trades near a 52-month high, yet investors’ allocation to stocks is below average (60.5% as of August). This is unusual.

In fact, in the 21st century there’ve only been a couple of instances where investors’ stock allocation was below average when the S&P was near a 3+ year high. Those instances are marked with a red arrow. In August 2006 stocks went on to rally. In March 2012 stocks declined first and rallied later.

Lessons Learned

The lesson for investors is A) not to follow the crowd and B) not to follow Wall Street or the financial media.

The mission of the Profit Radar Report is to keep investors on the right side of the trade. A composition of indicators used identified the March 2009 and October 2011 lows as investable lows and got investors out of stocks at the 2010, 2011, and 2012 highs.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.