Smart Money: An Early Warning Sign?

08/07/2013 9:00 am EST

Focus: STRATEGIES

It's not a surprise, or even unusual, to see public investors with a quite different take on the market than so-called smart money, and that divide has been quite obvious again in the current bull/bear market cycle says Sy Harding, of Street Smart Report.

The bull market got underway in March 2009, when Wall Street institutions, the trading departments of major banks, insurance companies, pension plans, and hedge funds began stepping back into the market, convinced the 2008-2009 financial meltdown had bottomed.

Meanwhile, the Investment Company Institute (ICI) says households are, by far, the largest group of investors in mutual funds.

So if we use money flows into and out of mutual funds as a proxy for the activity of public investors, it was about that time, 2009, that public investors, distraught and devastated after holding on through the 2008 financial meltdown, finally began pulling money out of the market.

And that divergence between smart money pouring money back into the market—while public investors pulled money out—persisted as the bull market continued right up until last fall. At that time, the ICI reported, money flows out of mutual funds had finally reversed to inflows.

The pace at which public investors had finally begun to pour money into mutual funds increased dramatically as we entered this year. It slowed only briefly, when the market pulled back from its record high in May, but has quickly picked up its pace as the market has returned to its peak again.

Meanwhile, so-called smart money turned quite negative on the market in April and May, and seems to remain so.

The evidence is not only in mutual fund flows, but in individual stocks. According to BofA Merrill Lynch's weekly data of client trading patterns, institutional clients have been bailing out of stocks this year, even as retail investors have been buying stocks at an increasing pace.

We'd also note that there have been 25 bear markets over the last 110 years, or one on average of every 4.4 years. This bull market, which began in early March 2009, is now 4.4 years old.

What makes it even more ominous is that we are in the first year of the Four-Year Presidential Cycle; history shows that most serious corrections and bear markets take place in the first or second year (or both) of the cycle.

The good news for investors may be that smart money tends to sell early while the market is still rising, while there are still bullish investors willing to take the other side of their sell orders.

The bad news is that smart money is regarded as being smart because of its history of buying low and selling high. That's something to think about.

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