Sunday, October 18, 2009

The Inflation Indicator Meets The "Dumb Money" Indicator

I thought it would be interesting to combine my inflation indicator, which is derived from the trends in gold, crude oil and yields on the 10 year Treasury, with the "Dumb Money" indicator, which is derived from widely available investor sentiment data.

Both indicators are now in that extreme zone, and I recently reviewed each indicator over the past week. The inflation indicator is in that extreme zone that should be a headwind for equities, and the "Dumb Money" indicator has been in the excessive bullish zone (i.e. bear signal) for 3 months now . Alone, each should produce headwinds for equities but what happens when there is a confluence of these two extremes - one detecting strong trends in gold, crude oil, and yields on the 10 year Treasury and the other detecting excessive and bullish investor sentiment?

Figure 1 is a weekly chart of the S&P500. The red dots over the price bars indicate when both the inflation indicator and the "Dumb Money" indicator are in the extreme zone at the same time. I have labeled each occurrence with the date. The two instances in the current rally were associated with the only meaningful pullbacks since March, 2009. The other three instances on this chart were associated with the run up to the 2007 bull market top.

Figure 1. S&P500/ weekly

Figure 2 shows those occurrences from 2003 to 2006. There were multiple dots that occurred throughout the bull run of 2003. For the most part, the bulls won out as this was one of those circumstances where it took bulls to make a bull market. But if you look closely, the dots at 7/25/03 and 10/10/03 did result in a trading range. Only the 12/12/03 signal resulted in a bull market blow off that was retraced over the next 3 to 4 months.

Figure 2. S&P500/ weekly

Figure 3 is from 1999 to 2003. The 1999 signal led up to the market top in 2000, and the bear market signals in 2001 and 2002 marked the highs that led to significant down legs. (Hindsight is 20/20!!!)

Figure 3. S&P500/ weekly

For the rest of the 1990's, there was only one other signal (not shown) and this was on 2/23/96, and this led to a 5 month trading range - the first real consolidation since the January, 1995 lows.

In the last 2 weeks, I have included the following words in my weekly articles on sentiment: "There is probably greater risk of a market down draft now than in past weeks." This past week I even underlined those words for emphasis. So why did I do that? When looking at these signals, it is clear to me that prior occurrences were associated with some fairly nasty 1 week sell offs, and I am not really considering those intermediate bear market highs from 2001 to 2002.

In a market driven by Dollar devaluation and "liquidity" this is what I would expect: there will be sudden down drafts that should be scooped up rather quickly as long as investor sentiment remains as bullish as it has been.


Anonymous said...

Ya but the problem is that it seems "dumb" money" are able to keep on pushing and pushing the market up...

dacian said...


" seems dumb money are able to keep on pushing and pushing"

And the risk is rising and rising... (between us, nothing go up indefinetly).

Guy M. Lerner said...

John Hussman writes the following in his weekly comments:

"The foregoing should not be interpreted as a "call" or forecast about sustained market direction. Rather, it outlines some of the factors are behind our defensive stance. As always, we align our investment position with the prevailing Market Climate, which does not require large or extended forecasts. I would be less than forthright, however, if I didn't admit that I suspect the current overbought condition may be cleared somewhat violently."

With my analysis, I have arrived at the same conclusion. This doesn't make it right because Hussman has come to a similar conclusion, but he is one of the best and brightest minds out there in my opinion. Although I have never met the man, he is one of the few people I would seriously give money to. Why? Because he is more interested in protecting capital than most people I have read.

Yes it is somewhat frustrating to watch the "Dumb Money" push the market higher, but I stated this many times on these pages: you don't have to play. Rather I will defend my track record and state that there have been better places to park my money over the past 4 months and most of these I have mentioned in these pages in a timely fashion.

Guy M. Lerner said...

One other thing:

Why is it that recently I get lots of comments that sound like this:

"The 'Dumb Money' has made another million today" or

"The 'Dumb Money' is right again"

You get the point. To me it sounds like a lot bull market geniuses. Now let's pretend there is no such thing as the "dumb money". The indicator doesn't exist. We would probably arrive at the same conclusion -as Hussman has - by just about every other metric.

Chris said...

Would it be possible to get a list of exact dates the indicator reached extreme levels? I'd like to average out SP500 returns for 1 week/month/3months/year for each extreme reading.

Very interesting analysis. Thanks.

Anonymous said...

Hussman has a long track record. But he has been wrong many times in the past, too. Like anyone who tries to predict the future, you are wrong as often as you are right.

I like his commentary and his cogent manner, however.

Guy M. Lerner said...


I like Hussman for similar reasons; I like his data centric approach and even with all that he has been very very defensive through out the rally