Dumb Money vs. Smart Money

Right now, it seems as though the market can do no wrong. It has been on steady increase the past few years, simply chugging along. Small investors are cautiously beginning to enter the marketplace, as their hope in a better tomorrow rises along with the price of stocks.

But as the stock valuations continue to increase, the risk of a bubble continues to grow.

We are faced with a multitude of risk factors that could cause implosion, ranging from the interest rate hikes, inflation, and tax reform. The market is going to have a lot to digest in the next few months.

Some of this digestion can be a good thing (think of it as fiber).

We are moving into a more pro-business environment, as evidenced by the President-elect and his proposed regulatory policies. Fiscal policy, with regards to the stock market, is becoming just as important in monetary policy, both in capping what businesses can do (Dodd-Frank) and allowing them to grow (tax reform).

Financial stocks (Bank of America and Wells Fargo, for example) will get a boost from overall deregulation due to Trump and the rising interest rates due to the Fed. But small-cap stocks, and other less protected industries will most likely be hurt by the Fed’s policies.

Tax reform will hopefully be a saving grace, as the smaller guys currently have less tax breaks as compared to bigger companies, and will benefit more from an overhaul of the current taxation system. Also, smaller companies will be less effected by the stronger dollar, as they tend to be more focused domestically, compared to their multinational counterparts with a more international reach.

An interesting take on the current market is published by the financial blog Sentiment Trader. (This links to a past report) For a fee, they provide a set of indexes called Smart Money/Dumb Money Confidence Indices. The Smart Money (Corporate dollars) is currently feeling less optimistic about the markets as compared to the Dumb Money (individual) investors. That’s a bit concerning for the average consumer.

The Fed has pushed this average consumer into the marketplace through its monetary policy. Faced with incredibly low returns on certificates of deposits due to incredibly low interest rates, “dumb money” is entering the marketplace with a newfound optimism. But as interest rates begin to rise, stocks (historically) begin to fall. And that money, dumb or not, is going to be effected by this increase in rates

Right now, the market is buoyed by corporate buybacks. Retail investors haven’t been boosting the market to new highs- it’s been corporations, attempting to increase the price of their stocks, and taking advantage of the dumb money that does enter the marketplace. When this fades (which it will) as of right now, the market doesn’t have a strong foundation to fall back on.

Bull markets don’t last forever. Bear markets don’t last forever. The market is cyclical. Picture a roller coaster- it’s full of ups and downs, and what goes up, must come down. As stocks climb higher and higher, there mathematically must be a reversion to the mean.

Luckily, as options traders, we know how to profit in any environment.

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

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