The Smart/Dumb Money Confidence indicator is reaching an extreme reading again and at one of the widest spreads on record.
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 take notice.
As of this morning, the Smart Money confidence has recently dropped to 29%; the lowest level this year. The Dumb Money confidence has just risen to 71%; making the spread between the two 42 points! These readings are each above and below the respective extreme bands of 70% and 30%.
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 not favorable and the probability of an increase in volatility rises with each passing day.
