For every turn in the market on a given timeframe, I think there are three groups of traders. First is the "smart money". My hypothesis is that this is the group which catches the turn BUT that membership in this group is volatile and there is enough churn in it that no member or group of members can always catch the turn. For proof, I would submit that no one can "corner the market", which someone who could catch EVERY turn would eventually do. For a while, membership can be glorious, but when a member loses the ability to catch the turns or tries to anticipate a turn too soon, it turns into a huge blowout. Members' equity curves are typically very jagged. Once a member begins to think it's smarter than the market, that's it. Since catching turns inevitably leads one to thinking one is smarter than the market, no member of this group can endure for very long. They end up on the covers of financial magazines one day and are yesterday's news the next. Second is the "smartest dumb money". My hypothesis is that this group never catches the turn (and probably doesn't try), but that their specialty is reading when the "smart money" has accomplished its goal of catching the turn. Some of the members of this group come from the "smart money" group, once they realized how volatile membership in that group actually is. Membership in this group is actually very stable because the "smart money" is actually quite easy to read, once they go into action. Instead of predicting a turn, this group reacts to the smart money's ability to make a turn "stick". My guess is that this is the group that actually has the smooth upward sloping equity curve everyone wants. Just from looking at the history of the trading business, my guess is that this group is the smallest and would include some of the long-lived, high-performing hedge funds and mutual funds. If true, the irony is that these firms go to all the trouble to hire the "best and the brightest" and then tells them "dumb it down so that you don't blow out like those other smart guys". Last is the "dumb money". My hypothesis is that they are the most numerous and that the first two groups distribute to them as they come in too late or they are the traders who try to catch the turn and be "smart money" and consistently fail. These are the traders who, at any given point, are in the midst of blowing out their accounts. Membership varies as new traders come in and some of these traders move into membership in the other two groups. This group's equity curve slopes down, down, down. There's a fourth group of "buy and hold" investors making regular contributions via 401(k) and IRA accounts, and other sorts of buyers and sellers like that, but they are not really traders nor do they really care about every market turn. Their regular contributions may actually come on a day which represents a turn, so they can find themselves in the "smart money" or "smartest dumb money" just by an accident of the calender. Unless they sell at a very inopportune time, they rarely end up as "dumb money". People who did this well for the decades of the 80s and 90s and had the luck to retire in the late 90s are the "millionaire next door" types. Lucky them! You might also include things like pension funds in here. They aren't trying to time the market, but they've got money to put to work. Anyway, this is just a model I use to think about traders and where they stand, who takes money from whom and what their "style" is. I'm curious to see if others think about this topic and where your thoughts differ from mine.
Zillion $ question is how to read when the smart money has put in their trades? To join the smartest dumb groupâ¦
I agree with this theory, though the second group is definitely the smartest. They know when The Market has discovered a temporary price that is becoming out of whack to the remaining possible transactions. The look on the chart is priceless.
That's all in the shapes of the movements. That tells you whether a move is ready to reverse, or not. I wait until the move halts and moves a few ticks in the other direction, that's confirmation enough for me, combined with the shape information.
George Soros, Reflexivity and Market Reversals http://seekingalpha.com/article/126165-george-soros-reflexivity-and-market-reversals " SUMMARY No matter how complex, the underlying basis of almost every economic theory is that markets search for prices that create a balance between supply and demand. Consequently, when all participants act rationally, free markets and the economy are stable. George Soros does not agree. His theory of reflexivity suggests that, sometimes, markets are inherently unstable. The underlying forces create negative feedback loops that cause prices to diverge wildly from equilibrium. Reflexivity helps explain why this happens and is the philosophy that he uses to identify these unstable environments. When prices move to the extreme, he bets on a reversal. As evidenced by his investment track record, Mr. Soros has applied his theories with great success. In this paper, we examine the ideas behind reflexivity and discuss how they result in parabolic price patterns. The belief that markets simply tend to overshoot in search for equilibrium is inadequate. When destabilizing forces take hold, businesses, industries and financial markets move along a relentless path away from equilibrium, sometimes creating a virtuous spiral of prosperity, and other times a vicious cycle of economic destruction. We conclude that when the destabilizing forces that caused the current bear market and economic recession finally abate, the U.S. will not be confronted with a so-called L-shaped recovery. In contrast, based on examples from history, stock market reversals in similar environments were V-shaped over a one-year timeframe. We illustrate why the conditions are now ripe for such a reversal. ... ... "
I agree that the second group, despite the name I've given them, is the smartest. Their methods are more stable, but, in the short-term provide less stellar returns than the first group. So, the first group always ends up at the top of the yearly returns lists, while the second group ends up at the top of those same lists measured in decades. With rare exceptions, those two lists hardly ever contain the same names.
I should have included as one of the traits of the "dumb money" that they will also be selling to/buying from the smart money during the initial stage of the reversal, depending on whether the "dumb money" was long too early or short too early. If long too early, they will sell to the smart money thinking that it's great to get out of a losing long position on a bounce or if short too early, they will cover a losing short on what they think is just a little retracement, not a full-blown reversal back to the downside. This accounts for where the supply comes from to meet the smart money's demand. The "smartest dumb money" gets its supply from dumb money with a little more patience, i.e. they cover those losing shorts a little lower (but still at a loss and too soon) or wait until the bounce on those losing longs goes a little higher (but not high enough for a profit). Some of this group's supply also comes from "smart money" getting out quickly, having already bought or sold near the bottom or top.
Sell in May and go away - it's an adage for a reason. I read an story somewhere saying that a large majority of 401k money is done by the end of May - most people who contribute don't take the whole year to max out. Also it's worth noting that most people add to their IRAs just before April 15th ~ Don't forget the end of the month runups which I believe is when mutual funds do alot of their buying. And the market ain't fixed ... haha
Good article and the timing of it could hardly have been better (written one week after the March 2009 low). "Stock prices have an annoying habit of turning higher ahead of many (or any) bullish news headlines. For this reason, we suggest the key to identifying extremes lies in the prices themselves. A study of historical stock market patterns during reflexive price movements can help us anticipate the turning point." The author, who does not seem to be affiliated with Soros, raises an interesting point by saying that Soros' theories "can help us anticipate the turning point". That would mean Soros is trying to be "smart money", according to the author. I wonder if Soros' actual method of placing trades would confirm this or whether it would show that Soros doesn't actually anticipate turning points, but reacts once enough evidence for the turning point exists. Given Soros' financial success, he could very well be one of the rare "smart money"-types with durability. A more generalized version of Soros' approach can be applied to all movements, not just the ones that are "reflexive". In my opinion, the market is always right in the instant, but it's also always wrong over time and that is why prices fluctuate. Prices reach an extreme and then the market collectively decides "It's time to be wrong in the other direction" and away it goes, with the various players playing their roles. The timing of the market's collective decision to reverse is, also in my opinion, completely and utterly unpredictable over the long run, which accounts for the volatility in membership in the "smart money" group. With a good model of the stages of the reversal process, however, a trader can discern the real from the fake reversals at better than even odds, i.e. can become the "smartest dumb money".