“Bloomberg’s Smart Money Flow Index is a measure of how ‘smart money’ is positioning itself in the S&P 500. The logic behind the index is that smart investors tend to trade near the end of the day, while more emotional-based traders dominate activity in the first 30 minutes of the trading day. The index is calculated as follows: yesterday index level – the opening gain or loss + change in the last hour. As shown below, the Smart Index and the S&P were well correlated until late August. Since then, as highlighted by the red arrow, they have diverged sharply. Over the last ten years, the S&P 500 and the Smart Index have a strong correlation of .65. As such, we expect they will converge in time. The light blue circle shows they also diverged, albeit to a much lesser extent, in January and
Lance Roberts considers the following as important: 401-k Plan Manager, Investing, newsletter, Technical analysis
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“Bloomberg’s Smart Money Flow Index is a measure of how ‘smart money’ is positioning itself in the S&P 500. The logic behind the index is that smart investors tend to trade near the end of the day, while more emotional-based traders dominate activity in the first 30 minutes of the trading day. The index is calculated as follows: yesterday index level – the opening gain or loss + change in the last hour.
As shown below, the Smart Index and the S&P were well correlated until late August. Since then, as highlighted by the red arrow, they have diverged sharply. Over the last ten years, the S&P 500 and the Smart Index have a strong correlation of .65. As such, we expect they will converge in time. The light blue circle shows they also diverged, albeit to a much lesser extent, in January and February as the smart money correctly sensed problems.”
Yields Have It
“The graph below compares 10 year UST yields versus 10 implied breakeven inflation rates. The current gap between the two is relatively wide but even wider, considering that UST yields are usually higher than the inflation rate, not lower. In other words, real rates are negative.
If the economy is going to fully recover, we should expect the UST yield to gravitate to and above the inflation rate. If that were to happen, it would imply 10-year yields of approximately 1.50-2.00%. We do not think the odds of that occurring are high because such “high” rates would heavily weigh on the economy. It is more than likely the Fed continues to aggressively buy bonds to keep yields much lower than where they should be.
The other way the gap potentially closes is if the market has inflation expectations wrong and the implied inflation rate falls. Such a scenario suggests the recovery falters.”
“Finally, the graph above shows the two components used to calculate real yields. As shown above, the blue line (UST yield) has made recent progress toward closing the gap with inflation expectations, ie real rates are now less negative.
The next graph shows the strong negative correlation between the level of real rates (blue line) and the price of gold. If real rates continue to rise and become less negative or even positive, we should expect the price of gold to suffer, and vice versa if real rates reverse the recent trend.”
Mom & Pop Finally Turn Optimistic
As noted, while “Smart Money” is leaving town, the bullishness of retail investors has finally spiked to the highest level in years. Such is months after the recovery from the lows. Historically, such has also been an excellent short-term contrarian indicator.
“The percentage of bulls in the American Association of Individual Investors (AAII) survey rose to 55.8% while bears dropped to 24.9%, pushing the Bull Ratio, a more accurate measure of optimism, above 69%. The last 2 times it got this high, stocks ended up running into trouble eventually.” – SentimenTrader
As Bob Farrell once quipped:
“Investors buy the most at the top, and the least at the bottom.”
Portfolio Positioning Update
When the market does things that are entirely unexpected, irrational, or just plain illogical, such is any living organism’s behavior. The stock market is just that.
The wild rotation from growth to value and back again was undoubtedly one of the unexpected events. Our job is to adjust our allocations to capture these rotations when trends are changing as portfolio managers. However, the difficult part is knowing the difference between a “kneejerk reaction” and a “trend change.”
On Monday, we decided to remain with our allocations, which already has some “value” to allow the market time to play out. That decision proved correct as our portfolio’s growth portion quickly came back into play after a rough couple of days.
More importantly, we took the opportunity to buy Treasury bonds, which got deeply oversold and 3-standard deviations below their moving average, as shown in the chart below. Such deep oversold conditions rarely last for long and generally lead to decent trading opportunities. That additional bond exposure played out well for the remainder of the week.
What’s The Biggest Mistake Investors Make?
My friend and trading colleague Victor Adair penned a great note last week:
“Interest rates are currently the lowest they’ve been in hundreds of years. In the early 1980s, people could get 13% interest on a bank account, but now ‘high interest’ accounts pay less than half a percent.
You might say that it’s wrong for savers to suffer because the Central Bank has cut interest rates to zero to support the economy. I’d agree, but the fact is that ultra-low interest rates have forced many otherwise cautious people into taking “a little more risk” to earn a decent return on their investments.
When people believe that they need to take ‘a little more risk’ to generate greater returns, they may be making a very BIG mistake if they underestimate what ‘risk’ really means to them.”
His point is incredibly important. As we noted in “Moral Hazard,” the Federal Reserve believes that insuring people against investment losses is a dangerous one. While investors are encouraged to take more risk currently, as prices rise, they begin to disregard risk for what it is.
When people take “a little risk” and get rewarded for it, they are then encouraged to take “a little more risk.” As Victor notes, “People in the ‘crowd’ don’t appreciate the risks they are taking because they’re surrounded by people who believe the market will keep going up.”
What Is The “Risk?”
“One way to measure ‘risk’ in today’s markets is to think of it as the difference between current market prices and the price where ‘value investors’ like Howard would start buying. Believe me; the difference is HUGE.” – Victor Adair.
The incredible stock market rally of the last 40 years has occurred while falling interest rates have forced more and more people to shift from being savers to being “investors.”
It’s not just the stock market. Virtually all asset prices have gone up as interest rates have tumbled. When there is no “hurdle rate” to the cost of money, then a lot of money gets “invested” poorly. There are very few bargain-priced assets these days.
As Victor notes, if we are indeed in another stock market bubble, then “valuations” don’t matter much. The only thing that matters is “confidence,” and if people are confident that the market will keep going higher, it will until something triggers a “loss of confidence.”
“In a bull market, the Fear Of Missing Out (FOMO) is so strong that people see marketing schemes such as “passive investing” as brilliant ideas. They willingly sign up to have money clipped off their paycheck and invested in the stock market every month, regardless of price. They do this because they have chosen to believe (or have been sold on the idea) that stock prices will only go higher.” – Victor Adair
Manage The Risk
Victor is correct when he states there has been much irrational exuberance in the past few years. Along with that exuberance, asset prices got bid aggressively higher. There is nothing wrong with that except that the “risk of loss’ from these levels is much greater now.
It is essential to have a strategy and discipline that can minimize downside volatility. If you don’t have one, then work with your investment advisor to assess your portfolio, risk, and risk tolerance. Decide if it is time to make portfolio changes. If not, then make plans to reduce risk systematically if the market starts to fall. That way, you won’t panic and make ‘spur of the moment” decisions if the market takes a tumble.
If you don’t have a disciplined investment strategy and are just part of the crowd, here are 10-rules of risk management to get you thinking.
How you chose to manage your portfolio is up to you. However, over the long-term, being aggressive without acknowledging the risks has tended not to work out well over time.
If you need help or have questions, we are always glad to help. Just email me.
See You Next Week
By Lance Roberts, CIO
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