The crisis generated by the Swiss National Bank, in which it announced that it will no longer place an artificial limit on the rise of their currency, has had a wide-ranging reverberation that did not just affect a select group of investors. Indeed, the natural assumption is that the dumb money, or the trading hysteria of the public masses, is the hardest-hit victim of market collapses. Of course, this assumption is based on the tragic tales of unbridled financial enthusiasm, whether the subject of focus is tulip mania or bitcoins. But in the case of the Swiss franc, which jumped in valuation against the U.S. dollar and the Euro to the tune of 30-percent immediately following the central bank announcement, the victims included multi-million dollar hedge funds.
According to a report from Bloomberg, Everest Capital’s Global Fund, which had about $830 million in assets, is shutting down after it blew up virtually the entirety of the account on an ill-placed bet against the rise of the franc (Burton, Katherine. “Swiss Franc Trade Is Said to Wipe Out Everest’s Main Fund“. Bloomberg. January 17, 2015. Web.). Although a crystal-ball into future market behavior has yet to materialize, much of the dramatics concerning volatility can be mitigated by simply understanding what the dumb money is doing and trading against them.
Who represents dumb money? The common mantra is that the general public is always swayed by yesterday’s news and by default are the perennial bag-holders. However, this definition can be expounded upon by including individuals or institutions that act in concert with popular sentiment and contrary to appropriate strategies. Put simply, the dumb money buys when they should sell, and sell when they should buy. Interestingly, the dumb money have been pouring out of the gold market (with some coaxing from the mainstream media) at a time when the fundamentals appear conducive towards accumulation of the yellow metal.
Although finding out who the dumb money specifically represents is a nearly impossible task without the assistance of confidential information, we can still garner a sense of their sentiment using a statistical tool called linear regression, which measures the relationship between a dependent variable and an explanatory or independent variable. Using a monthly chart of the popular gold fund GLD, we will define the dependent variable as selling pressure and the independent variable as time, with the end goal to determine patterns or variances for or against expected behaviors.
A polynomial regression (black dotted line) is used in the chart above to graphically illustrate the overall trend of total selling pressure. The regression is useful in determining where individual selling pressure is located relative to the prevailing trend and in identifying statistical outliers, or instances where data points are plotted multiple standard deviations away from the regression line.
One of the distinctive mathematical traits of the gold bears’ psychology is the transition from entropy to harmony. Between 2005 and 2012, the dispersion of selling pressure became wider and wider, as highlighted by the two orange lines in the above chart. But from 2012 onwards, selling pressure became compressed within a standard deviation of the regression line, as noted by the orange circle.
The interpretation of the data is surprisingly clear. As the price of gold increases, the first to initiate massive sell orders is the smart money, or institutional traders that initiated positions early in the game. This activity is captured as the “extreme-high” outliers. Following their moves is the dumb money, with the smartest of the dumb exiting just after the institutional traders, while the rest of the bag-holders exit at roughly the same time, which explains the aforementioned data compression. However, the loss of hope by the dumb money is ironically one of the best indicators of a market bottom and an opportune time to engage said market.
An inverse strategy towards linear regression is to find out what the smart money is actually buying. As it turns out, there is a strong argument for the return of a bullish cycle in gold and thus, an opportunity to acquire a potentially profitable position in the metal.