What's Behind The Rapid Plunge In The 'Smart Money Index'?

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by: Jesse Felder

Much has been made of the plunge in the Smart Money Index this year, and for good reason. In the past, major downturns in the index like we are witnessing today have proved to be prelude to major downturns in stock prices. Many have wondered about the underlying dynamics for the decline in the index of late, and I think it may be fairly easy to explain. The index simply represents the difference between the first 30 minutes of trading and the last hour. The idea here is that novice traders trade the open and more experienced traders trade the close. The difference reflects the net trading of these "smarter" traders.

However, the truth is that, with the dramatic rise in the popularity of ETFs, the markets have changed a great deal in the past decade. The vast majority of trading volume is not performed by individual traders but by algorithms. In addition, the vast majority of trade volume also now occurs during the last half hour of trading as passive and other systematic vehicles perform their daily balancing acts needed to match their benchmarks.

Another major change in the markets in recent years is that, more than ever before, stock buybacks dominate overall demand for equities. So far this year, they have surged to a record pace. Considering the fact that buybacks are prohibited during the final half hour of trading, it could be that the smart money index simply reflects the difference between corporate demand for equities (early in the day) and the natural investor demand for equities (largely reflected at the close).

And while corporations are buying hand over fist, individual investors have turned net sellers of equities over the past year. This would seem to confirm the idea that the plunge in the smart money index of late is simply a product of surging corporate demand amid waning retail demand for equities.

Still, even if this does explain the rapid decline in the smart money index, it probably doesn't do much to ameliorate its dark message. There is reason to believe that waning demand on the part of investors could be, at least in part, the product of a major demographic shift. This leaves the stock market entirely at the mercy of corporations, which are notoriously bad at market timing. In fact, looking at the chart above that tracks stock buybacks, you might say they are the dumbest investors in the market, pouring record amounts into equities at the highs and dramatically paring their buying at the lows. For this reason, the smart money index may live up to its moniker once again, even if the underlying dynamics have changed so dramatically since the indicator was first introduced.