The Rude Awakening Wall Street, New York Wednesday, January 28, 2005 ------------------------- The Rude Awakening PRESENTS: Dumb money is like a
Financial Hydra. Although it has many heads, all belong to
the same dumb organism - a creature with an uncanny
knack for buying or selling stocks at precisely the wrong
time. Here's how to slay it… ------------------------- THE DUMB MONIES
By Eric J. Fry In a perfect world, "dumb money" might not exist. But the
world is not perfect. This little orb we call home has a
few glaring defects - like mosquitoes and freezing rain and
the New York Times. But rather than complain about life's adversities, your
editors here at the Rude Awakening always try to find ways
to make lemons into lemonade, or, if you prefer, cactus
into tequila. Dumb money is here to stay, whether we like it or not. So
we might as well figure out ways to turn this negative into
a positive. Fortunately, the task is relatively simple: If
the dumb money is buying, sell. In general, it is best to
"fade" the dumb money's activities - in other words to move
gradually against whatever they are doing. In recent weeks, the dumb money has been loading up on
stocks - a worrisome trend in and of itself. What's
somewhat more worrisome is that the dumb money remains
bullish and confident, even though share prices are
falling. "Dumb money" takes many forms, but its underlying nature
rarely changes. It never becomes "smart money," for
example, though it make masquerade as such for a while. Dumb money is a financial hydra - one head may be that of
an odd-lot options trader, another might be an AAII survey
respondent, another a "small speculator" in the commitment
of traders report, and another might even be a commentator
on CNBC. Each head of the Hydra is different of course, but all are
part of the same dumb organism - a creature with an uncanny
knack for buying or selling stocks at precisely the wrong
time. Monitoring the activities of the dumb money,
therefore, can sometimes offer helpful clues about the
direction of financial markets. So let's take a moment to have a face-to-face-to-face-to-
face with this Hydra and try to gauge where the stock
market may be going next. First up, options buyers on the Nasdaq 100 Index remain
remarkably bullish, despite the index's nearly 10% drop
from its January 3rd high. Like every other type of dumb-
money crowd, this one tends to become most bullish as
stocks are topping out, and most bearish as stocks are
bottoming out. "If a good, healthy advance were under way," options pro
Jay Shartsis noted yesterday, "we would be seeing much more
put-buying. This recent sell-off has been truly remarkable
from the standpoint that so few investors are buying puts.
There is simply no fear in the marketplace. "At the market peak last January, the dollar-weighted
Nasdaq 100 Trust (QQQQ) put/call ratio got down to about 55
cents in puts traded for every $1 in calls. This signified
a high level of option trader optimism, and then the market
fell broadly into March 2004. At that bottom, the ratio got
all the way up to $1.55 traded in puts for every $1 in
calls (high level of pessimism), and stocks turned up
again. "By the end of last month," the savvy options trader noted,
"this ratio has dropped all the way down to about 53 cents
in puts traded for every $1 in calls. This, again, was a
very high level of option trader optimism, and we are now
back in sinking mode. At last report, this ratio is at
about $1 in puts trading for every $1 in calls, and it's
rising. I suspect we will see at least $1.50 - and readings
above $2 wouldn't surprise me either - on this indicator
again when stocks are ready to rally." "Okay, you've got me sufficiently worried," your editor
replied. "Wait! There's more!" Shartsis continued, "The VXN Index
[measuring options volatility on the Nasdaq 100 Index] has
moved up surprisingly little from its nine-year low near
16, with today's close at 18 and a half. Where's the fear?
How about a couple of days of serious put-buying? This
thing should have spiked up to 25 or 26 by now if the sell
off were close to exhausting itself." The "odd-lot" options traders - known to be among the
dumbest of the dumb money cohorts - are similarly bullish.
"The odd-lotters [i.e. option buyers trading less than 10
contracts] are fearless," said Shartsis. "They are still in
bullish mode as the ratio of puts to calls for those little
guys is just .44 (that's 44 puts traded for every 100
calls) - not at all far from the .33 extreme reached in
late December as prices peaked. At the March 2003 stock
market bottom, this ratio was at about .98 (that's 98 puts
traded for every 100 calls). That's a long way from here.
The S&P 500 got to just under the 1175 level Wednesday -
the bottom of the prior trading range - and that's probably
as much upside as it can manage now…" Small futures traders are also brimming with confidence,
which is almost never a good sign. As the nearby chart
illustrates, the "small speculators," as they are called,
have amassed their largest net-long position in S&P 500
futures contracts since the market peaks of March and June
2004. (The careful reader may also note that small
speculators moved to their smallest long position of 2004
during the week of November 2nd, just as the stock market
lurched toward its best rally of the year.)  Not surprisingly, the commercial traders - the
"Commercials" - are taking the other side of this trade.
The Commercials, often called the "smart money," have
amassed a rather substantial net-short position in S&P 500
futures contracts. They have placed their biggest bet
against the stock market in recent memory. "The stock market is setting up for a significant decline
beginning early this year and continuing into 2006,"
Comstock Partners warns. "Early 2000 marked the end of an
18-year secular bull market similar to those from 1921-to-
1929 and 1949-to-1966. Each of these periods was followed
by multi-year secular bear markets. The peaks of the bull
markets were featured by high valuations, excessive
speculation, investor euphoria, and a belief that markets
had reached a permanent new level of high valuations (a new
era). "In our view current conditions resemble those of past
tops," Comstock continues. "The S&P 500 is selling at 21
times trailing reported earnings with a skimpy dividend
yield of 1.8%. Investor sentiment is frothy while equity
mutual funds maintain historically low levels of cash as a
percent of assets. At the same time the Fed has now raised
rates at each of last five meetings with a sixth one likely
soon…The federal fiscal policy that created a strong
tail-wind for the market over last two years is now in the
process of reversing and becoming a head-wind instead. "The market has gotten off to a poor start in January,"
Comstock concludes, "indicating a potential end to the
counter-cyclical bull market of the past two years as the
new money flows so widely expected have so far failed to
materialize…Although the recent drop has brought the
market into temporarily oversold territory and a test of
the recent highs is still possible, we think that the risks
have increased substantially and that stocks are highly
vulnerable to a sudden downdraft." Maybe then, the dumb money will be selling. [Ed. Note: Concerned you might be dumb money? Let our in-house options trader Steve Sarnoff help. He runs
a service called Options Hotline and since January 1, 2004,
he has made 34 option recommendations…and 30 were
winners. 11 of them at least DOUBLED in value. Here's more information: Options Hotline
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By Eric J. Fry The pictures below speak for themselves, but maybe not in a
language every Rude Awakening reader would understand.
Allow us to translate: the America consumer is probing into
new frontiers of fiscal imprudence. As the first chart illustrates, we Americans (in the
aggregate) are behaving as though cash is trash. For the
last several years, we have been running deficits to fund
our consumption and our home-buying. This national
"dissaving" boom appears to be gaining momentum, thanks to
the related "cash-out" mortgage boom.  Because credit finance has become so readily available,
deficit spending has become seductively simple. But the
second chart raises the possibility that debt-financed
consumption will not continue forever. Total household debt
as a percentage of total household assets is skyrocketing.
In a low-interest rate environment, servicing this growing
mountain of debt poses little problem. Should rates rise
however, the debt mountain might begin to squeeze household
finances and, eventually, crush consumer spending.  Come to think of it, the real estate market might also feel
the effects of rising rates. [Ed. Note: Total household debt? Consumer Spending?
The Refi Boom? Do any of these macro-indicators mean anything?
How do you make money off the REALLY BIG trends? Or…can you at all? Don't miss The Great Profit Debate at the World Money Show in
Orlando, Fl, next Thursday. Investment heavy-hitters Dan Denning
and James Boric are going to duke it out live. Denning is a big-
picture macro-guy who plays options on ETFs. James, an inveterate
small cap sleuth, could care less…he's buying great companies
cheap on their fundamentals - and watching them skyrocket in value. "The Great Profit Debate" will be moderated by New York Times
Best-selling author (and publisher of the Rude Awakening)
Addison Wiggin. Stuck in the middle will be value seeker Chris
Mayer, editor of the Fleet Street Letter. Chris has his own approach
he calls: "Tangible Assets That Sweat." Chris does just fine
in any market. You don't want to miss it…when these guys get together for a
tussle…follow this link for details: The World Money Show - admission is free!
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