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Amid Stock Market Euphoria, the Smart Money Is Fading


Perhaps the smartest of the smart money operate in the US Treasury market, where the most glaring divergence is occurring.

With the first quarter in the bag and the stock market at new highs, I wanted to recognize and analyze a couple of interesting divergences that are developing among what I would consider smart money investors, and may be telling a different story that what you are hare hearing from media pundits and Wall Street strategists.

With speculators maintaining record long positions in the S&P 500 (INDEXSP:.INX) e-mini after being short for most of the rally off the 2011 lows, it's pretty clear to me that underexposed hedge funds are behind this parabolic advance. Hedge fund investors might even have to dole out performance fees this quarter to managers who were only now just able to catch up to their benchmarks. In order to keep the party going the specs are going to need others to hop aboard the train, and as I pointed out last week in QE Correlation Does Not Imply QE Causation, I thought the opposite was happening:
This change in positioning is very important because, as evidenced by the increase in volume since the beginning of the month, I believe there has been a big shift in ownership of this market from real money into levered accounts.

Clearly the 1550 area is bringing out the big sellers and the buyers have exhausted a lot of ammo in order to absorb the supply. Considering the recent spike in speculator positions I believe the levered money is trying to defend this 1550 level. The question for the future direction of the market is whether they have the bullets left to take the market higher.

ES COT Large Speculators Net Position

It's not just speculative positions that point to this change in equity ownership it can also be identified in the relationship between Bloomberg's Smart Money Flow Index and the Dow Jones Industrial Average (INDEXDJX:.DJI):
The Smart Money Flow Index is calculated by taking the action of the Dow in two time periods: the first 30 minutes and the close. The first 30 minutes represent emotional buying, driven by greed and fear of the crowd based on good and bad news. There is also a lot of buying on market orders and short covering at the opening. Smart money waits until the end and they very often test the market before by shorting heavily just to see how the market reacts. Then they move in the big way.... Whenever the Dow makes a high which is not confirmed by the SMFI there is trouble ahead.

Smart Money Flow Index Vs. DJIA

According to Bloomberg's calculations, the so-called smart money investors were the most exposed last September and have been fading this most recent leg of the rally. The ratio of the DJIA/Smart Index is at the widest since the 2009 low, pointing to a clear divergence in smart money participation as the Dow hits a new high. Of course, this in and of itself does not mean stocks are topping and divergences can continue for long periods of time, but I think it does help support my thesis that the ownership has changed from strong real money into weak levered money hands.
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