Lots Of Dumb Money On The Sidelines: Should Smart Investors Buy Stocks?

Includes: DIA, QQQ, SPY, TLT
by: James A. Kostohryz

We've all heard the story: Joe Sixpack was scared out of his wits by the 2008-2009 crisis and he sold out near the lows. Now he's got piles of cash idly sitting on the sidelines and he is feeling incredibly anxious about having missed out on the 100%+ tear that the Dow (NYSEARCA:DIA) has been on for almost four years. Furthermore, Joe Sixpack is incredibly frustrated by the fact that the money that he has in money market accounts, savings accounts or bond funds (NYSEARCA:TLT) is earning next to nothing. He simply can't stand earning zero return on his money anymore while everybody else is getting rich in the stock market.

So, what are the experts that endlessly repeat this narrative telling us to do right now?

Buy stocks, of course.

Follow The Money

It appears that the latest brilliant investment thesis being promoted in various media by financial commentators and even some big-time money managers is the following: There are all of these dumb people out there that own boatloads of bonds and/or have tons of cash lying around. The trick is to get into stocks now, right as all of this dumb money is about to "rotate" out of bonds and cash and start flooding into the stock market and cause a massive blow-off rally in equities.

So the plan is: Follow the dumb money!

Sounds like a great plan, right?

The New Investment Method: Buy What The Smart Money Is Selling

So, we are being told that it is smart to do as the dumb money does, or is about to do. But have you asked yourself: Who are the generous folks that are so graciously going to sell their stocks to the dumb money - i.e. the Joe Sixpacks of the world?

Well, if the cash on the sidelines belongs to the dumb money, presumably the heretofore smarter people that currently own stocks are the ones that are going to provide the dumb folks with this tremendous investment opportunity. In this exchange, the dumb money will hand over their underperforming cash to the smart money and in exchange, the smart money will hand over to the dumb money their tremendously outperforming equity assets such as (NYSEARCA:SPY) and (NASDAQ:QQQ) that have risen over 100% in less than 4 years.

So we have a new era investment paradigm: After a long bull market, search for what the dumb money is buying, and purchase what the smart money is selling to them.

Sounds like a smart plan, right?

Old School: The Concept of Distribution

Back in the old days it used to be taught that intelligent investors should sell when the dumb money is buying (and buy when the dumb money is selling). The following classical narrative was often used in some form to illustrate the point:

After a long bull market, the dumb money that has been nervously sitting on the sidelines watching the stock market get further and further away from them become increasingly anxious with envy until they finally capitulate and start buying stocks. At that very moment, the smart money starts realizing their profits by selling their stocks to the dumb money. This process is called "distribution." It was taught that intelligent investors and traders should sell their stock holdings right before or during the distribution stage because this represented the final phase of a bull market, and the beginning of a change of trend.

A friend recently reminded me of a saying that old-school brokers used to apply in connection with the concept of distribution: "When the ducks start to quack, it is time to start feeding them."

In other words, when the broker's phone rings, and it is Mr. or Ms. Dumb Money (that have been on the sidelines for a long time), that is calling to inquire about buying stocks, it is time to start selling shares.

Please note that this old school storyline stands in sharp contrast to the "follow the dumb money on the sidelines" narrative that has recently been marshaled in support of the theory of the Great Rotation and other related theses that have become very popular. According to the advocates of these new schools of thought, the ducks have started to quack, and this is the signal for investors to go out there and gorge on stocks, right alongside the ducks.


In my most recent article, I thoroughly and definitively debunked one of the most pervasive and deeply rooted notions in the entire investment world: Namely, the myth that people should buy stocks when there is lots of money "on the sidelines." If you have not seen that article, and the extraordinary discussion that followed it, I highly recommend that you read it, study it and commit it to memory. Truly, if you have not fully comprehended and internalized the lessons contained in that article, there is little hope for you as an investor or trader.

In the present essay, I hope that I have made it clear that a misbegotten cousin of the "money on the sidelines" meme - the idea that after a long bull market you should purchase stocks that the "dumb money" is about to buy and the smart money is about to sell - traverses the full distance from falsehood to absurdity. Even if it were true that there was lot's of "dumb money on the sidelines" that is itching to buy stocks - i.e. assuming it were possible to identify and quantify such things - the logical investment conclusion would be that investors should be preparing to sell stocks, not to buy them.

Having said that, as we saw in 2012, truly dumb money can be made to look smart when the market goes in the direction that they predicted, albeit for other reasons. Dumb money is always wrong in its investment rationale, but it will sometimes be profitable. That is just a matter of probabilities. So with this in mind, I want to make it clear that I am not making the opposite market forecast than the one that is being trumpeted by the adherents of the "dumb money on the sidelines" school. As I outlined in my 2013 outlook I am relatively constructive on the prospect for global equities in the medium term for completely different reasons, including potential shifts in liquidity preferences combined with the high and rising levels of cash around the globe.

Please note that the quantity of cash and people on the sidelines does not determine stock prices. However, as I explained in my most recent article referenced earlier, if available cash levels in the economy are abnormally high (or low) and changing significantly and the marginal preferences of people (on and off the sidelines) for cash relative to other assets are shifting (or on the verge of shifting), significant price changes may follow.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.