Contrarian Investing 101: Smart Money, Dumb Money - What's In Your Pocket?

by: Craig Brockie

We've all heard the saying that the rich get richer and the poor get poorer. Unfortunately for the average investor with a portfolio of mutual funds or individual stocks and bonds, this saying holds true.

We are now in the fifth year of an epic bull market in stocks that has seen the S&P 500 (NYSEARCA:SPY) increase over 2.5 times. Much like late 2007, we are again at all-time highs in the markets and some investors may finally be in the black again after the devastating set back they experienced in 2008. Not so fast though, the price of gold is 80% higher today and the price of gasoline is 30% higher. After factoring in inflation, today's stock prices and investment account balances are actually still in the red by a wide margin. Before you kill the messenger, let me continue. There can be a happy ending to this story.

The chart below is one of my favorites right now as it shows the big picture regarding what we've experienced over the past 20 years in the US stock market, as represented by the S&P 500 index.

20 year chart of S&P 500

What stands out to you in this chart? Where do we appear to be in the pattern right now? What do you think is most likely to come next?

I agree if you concluded that we are likely to soon transition into a new bear market and within the next two years experience another crushing low. What happens in between now and then will determine who will be richer and who will be poorer.

In the investment world, the typical outcome is that the confused and unprepared masses (aka the Dumb Money) unwittingly transfer massive amounts of wealth into the hands of a small number of investors who actually understand the what's going on (aka the Smart Money). The Smart Money employs a contrarian investment strategy, buying assets that most others are selling and selling assets that most others are buying. This generally equates to buying low and selling high, the holy grail of investment success.

While some contrarian investors hold their cards close to their vest, the biggest players within the Smart Money group actually disclose their trading activity. That's right, the biggest of the big within the Smart Money crowd show us every move they make. Based on this fact, it is shocking how few people use this information to their benefit.

In this article, I'm going to share with you exactly who the biggest Smart Money players are and what they are investing in today--at record levels, so you can join in their upcoming success.

The Smart Money consists of two groups. The first group are commercial traders. These are professionals who trade the futures market, primarily to offset risks related to their business activities. For instance, a manufacturing company that is highly dependent on copper for its products would have commercial traders working to lock in their ability to buy copper at a set price. This activity protects the manufacturer so that a major increase in copper prices would not affect their bottom line.

Commercial traders recently have been taking record positions in some very interesting areas, which I'll get into the specifics of soon.

The second major group of Smart Money investors are those who are significant shareholders and board members of publicly traded companies. These are highly successful people and in the case of top corporate executives, understand the present and future value of their companies better than anyone else. When these Smart Money investors are opening up their wallets to risk their own savings to buy more shares in the companies they control, what does that suggest to you? Corporate insiders have recently been buying at record high levels in a particular sector.

Again, the good news is that the Smart Money shows us what they've done so we can follow their lead. Now let's look at exactly what these guys have been loading up on recently at record levels.

Last week, commercial traders took the most bullish stance on gold since May 2005. That's an eight-year extreme ladies and gentlemen. If that's not enough, commercial traders are the most bullish they've been on silver since July 1997, almost 16 years ago! The following two links show the past 12 months of data for commercial traders commitments for gold and silver.

It doesn't surprise me one bit that commercial traders are taking this stance. We've had a bull market in gold since it bottomed at $252.80 on July 20th 1999. Yes, it's been raging almost 14 years now and I believe it's far from over.

Further more, gold reached a major oversold extreme in mid April and has been setting a bullish pattern of higher lows ever since. The trend has reversed and the commercial traders know it. This is obvious based on their current bullish stance.

Gold bottomed in April

For the full story on what I believe you can expect in the gold market over the next 10 months, read "Gold: The Recent Collapse and Approaching All-Time High". This article was published on April 15th, the exact day the gold price reversed.

Now, let's talk about what the second group of major Smart Money players have been doing lately at record levels. According to this recent interview by The Gold Report: "When gold sold off in April, our indicator for the gold group jumped substantially. It got as high as 10:1, meaning 10 gold companies had key insider buying for every one that was selling. That is an astronomically high level of buying."

Buying of mining shares by top corporate executives, especially in junior companies, has spiked near all important bottoms this quarter, including the past several days. What do these guys know that everyone else doesn't? Why are they especially willing to risk their retirement savings to load up on their own company's shares?

I cannot speak for them, however I suspect they are acting out of logic and greed. Logic, because they are confident their companies will survive and greed because they realize their risk capital will increase an average of 66% simply if their share price regains its current 200-day moving average price. See for yourself, here's a chart of the junior gold mining fund (NYSEARCA:GDXJ) with its 200-day moving average.

GDXJ ready to blast off in price

It may seem counterintuitive to you that the general stock market (as represented by the S&P 500 index in the first chart in this article) appears to nearing a major bear market and the Smart Money and I are bullish on gold mining stocks. After all, gold mining stocks dropped along with everything else in late 2008.

The reason for this may again based on historical precedent. The following chart shows what happened in the nine months after the S&P's previous all-time high. The red line shows the price of the S&P 500 index and by July 2008 and as you can see, the decline was gradual, but far from shocking up to that point. Meanwhile, the price of oil as represented by the fund (NYSEARCA:USO) in the chart below, made huge gains. In fact, commodities of all varieties, including gold, rallied strongly in the first half of 2008.

oil prices versus S&P 500 in 2007-2008

Right now, the Dumb Money looks to me like a deer caught in headlights. Danger is fast approaching, but they're frozen, confused and not sure what to do. Meanwhile, the Smart Money is not just taking action, but decisively so and to a record high degree.

Buying into the gold mining sector can be done to suit most risk tolerances. The senior mining fund (NYSEARCA:GDX) is probably the lowest risk way to participate. If you prefer individual names, then Barrick Gold (NYSE:ABX), Newmont Mining (NYSE:NEM) and Goldcorp (NYSE:GG) are three of the biggest in that class. An investor with a higher risk tolerance could consider the junior gold mining fund or its components. The most speculative choice are gold exploration companies. The fund (NYSEARCA:GLDX) focuses in this area. An investor restricted to mutual funds could simply buy ones that focus on the production of precious metals.

I hope you found this article informative and helpful. I appreciate you following me here on Seeking Alpha so I can share future articles about contrarian investing with you as they are published.

Disclosure: I am long GDX, GDXJ, GLDX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.