The term "dumb money" is pejorative and we never intended it that way. It just kind of stuck when we started computing in more than 20 years ago. For the most part, these indicators reflect retail, mom-and-pop types of traders, but certainly not exclusively. Sophisticated institutional investors have just as much propensity to suffer from group-think as everyone else, so determining "smart" and "dumb" is not necessarily straightforward.
The term "dumb" itself needs to be clarified. A more accurate description would simply be "trend-following." Most trend-followers are not dumb - they're positioned correctly during the meats of most major trends. That sounds pretty smart.
Where this term gets its meaning is that because trend-followers use different methodologies, some waiting until trends are well-established, by the time most trend-followers hop on a trend, and most aggressively, is about the time the trend is becoming exhausted. So these traders tend to be the most net long near peaks and least net long (or most net short) near bottoms. Because most investors follow trends to some degree, these indicators tend to capture the behavior of most of the money flowing into and out of markets.
When Dumb Money Confidence is above 70%, the S&P 500 advances at an annualized rate of 3.0%.
When sentiment is pessimistic and starts to recover, it often pays to do one or more of the following:
- Add any available cash to stocks
- Shift a portfolio to more aggressive, higher-beta stocks, sectors, or indexes
- Remove or reduce existing hedges
- Sell (covered) out-of-the-money put options to take advantage of time decay and pumped-up implied volatility levels
- Establish some speculative positions via call options or leveraged ETFs
When optimism gets very high (especially in an unhealthy market environment), it almost always pays to become more defensive. That means potentially:
- Selling down positions and raising cash
- Shifting a portfolio to defensive stocks and sectors
- Moving to non-correlated assets like bonds or gold (though it's difficult to rely on intermarket correlations)
- Selling (covered) out-of-the-money call options to take advantage of time decay while stocks likely plateau or decline
- Establishing hedges like buying put options or inverse ETFs