Wall Street pros and everyday investors have dramatically different views on the market. Here’s why the chief strategist at Charles Schwab says that could spell deep trouble for stocks.

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traders disagree

  • Data suggests that there’s a growing split between some of the most experienced investors on Wall Street and the least.
  • According to statistics from SentimenTrader, hedge funds and institutional investors are growing more pessimistic about stocks while retail investors are getting more optimistic.
  • Liz Ann Sonders, chief investment strategist for Charles Schwab, says that when the two groups disagree, the experienced investors are usually right.
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As much as Wall Street focuses on hard numbers like earnings, sales, and GDP growth, feelings are never far behind — although traders prefer the more concrete-sounding term “sentiment.”

The importance of sentiment usually boils down to a few basic ideas. Are investors comfortable putting their money into the market? Are they more fearful than the facts say they should be? Are they irrationally optimistic, signaing they’re unprepared for trouble?

But questions like that can lump all investors together. Liz Ann Sonders, chief investment strategist at Charles Schwab, which has $3.8 trillion in assets under management, says she pays attention to lots of measures of sentiment, but is looking at a more complex question today: How are different groups of investors feeling?

Sonders explains that institutional investors, hedge funds, and other longtime pros are getting more pessimistic about the performance of stocks, while individual investors are getting far more optimistic. And the gap between them is getting large.

When those two types of investors strongly disagree, history shows that the first group is usually right and the second group is wrong — which is why Sonders and a lot of other pros call it “the smart money” and the second group “the dumb money.”

“Typically at extremes and directionally, the smart money tends to be right and the dumb money tends to be wrong,” Sonders said in an exclusive interview with Business Insider. That is, if the smart money is worried and dumb money is hopeful, the market is likely to fall. In the opposite scenario, stocks usually go up.

There are lots of investor surveys, but Sonders says she’s keeping an eye on how these two groups are actually positioning their money. One importance source of data for her comes from Sundial Capital Research’s SentimenTrader, which aims to track the behavior of both groups of investors.

The firm’s Smart Money Confidence tracker includes data such as the relationship between stocks and bonds and commercial hedge fund positions inequity index futures. It also has a Dumb Money Confidence statistic based on inputs like stock-only put/call ratio and tracking small speculators in equity index futures contracts.

The chart below backs up the idea that there’s a growing split between the two sides. It shows how wide the gap between “smart money” and “dumb money” has been over the past 10 years. It’s been more extreme a few times over the last decade, including late last year, shortly before the market nosedived.

Sonders says that the trend could be a sign of danger for stocks.

Smart vs. dumb money

“Sentiment has started to look a little bit frothy,” Sonders said, with stocks at all-time highs as investors focus on positives like the health of the economy, lower interest rates, and the “phase one” trade agreement, and ignore threats like fallout from the broader trade war and its effect on business investment.

“When sentiment starts to reflect that at an extreme, that tends to be a contrarian indicator for the market because it sets you up for disappointment,” she added. “If everybody is optimistic and everybody thinks the market is great, they’re probably invested already and there’s not as much fuel going forward.”

SEE ALSO: ‘I would always rather be late’: A chief researcher advising a $67 billion fund reveals his strategy for avoiding disaster in a market obsessed with growth

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