As a refresher, the Confidence indices are presented on a scale of 0% to 100%. When the Smart Money Confidence is at 100%, it means that those most correct on market direction are 100% confident of a rising market, and we want to follow their direction. When it is at 0%, it means that the Smart Money are 0% confident in a rally, and we want to be more defensive and hold more cash.
We can use the Dumb Money Confidence in a similar, but opposite, manner. For example, if the Dumb Money Confidence is at 100%, then that means that the Dumb Money investors are supremely confident in a market rally. And history suggests that when these investors are most confident, we should exercise extreme caution. When the Dumb Money Confidence is at 0%, then from a contrary perspective we should be concentrating on the long side, expecting these traders to be wrong again and the market to rally.
In practice, the Confidence Index numbers rarely get below 30% or above 70%. Usually, they stay between 40% and 60%. When they move outside of these levels, it’s usually time to pay attention.
As you can see by the chart above, the Smart Money confidence has recently dropped below 40%, or below the first band of 40% to 60%. The Dumb Money confidence has recently risen to 75%. This reading is above both the 40% to 60% band and above the rare band of 70%. Again, this doesn't mean that markets will decline immediately and the markets could actually continue to move higher in the short-term. However, the risk/reward equation is definitely not in our favor and the probability of a decline in the markets increases the higher this number becomes, especially if the Smart Money Confidence moves toward the 30% level. This confidence index coupled with the Investors Intelligence survey numbers from last week suggests that investors are becoming very comfortable with the markets continuing to rise; which should make us a bit cautious.
