'Smart Vs. Dumb' Money Is Not A Useful Trading Paradigm

 |  Includes: DIA, IVV, QQQ, SPY, SSO, VTI
by: Dr. Duru

On Wednesday, May 9th, CNBC ran a story with the following headline: "Stocks Trim Losses Yet Again: Is the Morning 'Amateur Hour'?." The Article ran on the heels of two straight days of stock market rallies off early morning lows. Based on just these two days of trading, the article concluded that anyone trading against the "dumb money" in the morning, made a lot of money. The article even quoted a hedge fund manager as saying "Amateur hour is 9:30 to 10:30…Smart money trades later in the day. Risk is definitely to the upside here."

Never mind that in order for the smart money to make money daytrading off the dumb money, the smart money needs dumb money to buy back their stocks by the close - but that would mean dumb money dominates the end of the trading day. Never mind that no data were offered to support the implication that the close of the day consistently reverses the open. Indeed, my 2010 study of trading opening gaps in the SPDRs S&P 500 Trust Series ETF (NYSEARCA:SPY) showed that only a minority of gaps gets reversed (see "Opening Gaps: Bigger & More Important" in SFO Magazine. Subscription may be required). What struck a chord with me is that even after so much data appear to demonstrate that retail investors and traders appear to be retreating and staying away from the stock market, we still read insults like the ones posted in this CNBC article. Any wonder that retail stays away from a system that seems rigged specifically to transfer money from them to institutional traders?

It just so happens that on Tuesday, I tweeted that it was time to buy call options on ProShares Ultra S&P 500 (NYSEARCA:SSO). It was not based on the thinking that dumb money was dumping stocks, only that negativity had reached a (temporary) extreme. Moreover, recent data suggest that the market tends to recover on Wednesday following Tuesday selling (see "S&P 500 Performance By Day Of Week And The Changing Nature Of Trading Tuesdays"). Wednesday instead only delivered a recovery from its own lows for the week. The overall impact is that the market still closed on Wednesday at the lows for the week. So far, dumb money does not seem so dumb. For Thursday's trading, the market rallied early and closed weak. Once the S&P 500 hit its high for the day right where it closed on Tuesday. So when did dumb and smart money flow this time? Is the market still bullish or is it bearish now? I claim it is near impossible to tell through a "smart vs. dumb money" trading paradigm. (I happen to think the market is slowly peaking).

The chart below shows a close-up the action. The S&P 500 is dangerously close to turning bearish as it slowly fades from the last breakout area to multi-year highs.

S&P 500 is barely clinging to the last important breakout area and support

S&P 500 is barely clinging to the last important breakout area and support

Source: FreeStockCharts.com

Within the context of "sell-in-May," the S&P 500 looks particularly ominous (my latest examination of the sell in May pattern suggests that if you must sell, it is best to do so in early May or the end of the month). I cannot say whether it is smart or dumb to do so, especially since each person's risk tolerance and trading horizons differ, but I will claim that it pays much better to follow the data rather than your ego.

Be careful out there!

Disclosure: I am long SDS.

Additional disclosure: I am also long SSO calls