The Smart Money Flow Index states that “smart money” trades during the last hour while the dumb money trades during the first hour. The Index adds the Dow’s daily close $ and subtracts the Dow’s daily 10 am price. This means that if the market opens high and closes low, the “smart money” must be selling.
Click here for the latest data on the Smart Money Flow Index
The Smart Money Flow Index has fallen much more than the S&P 500, meaning that over the past 2 months the Dow has had a strong tendency to fall during the last hour of trading.
As you can see from the chart above, this massive divergence between the Smart Money Flow Index and the stock market has only happened twice since 1982: once in early-2000 and once in 2006.
- The 2000 case clearly marked the top.
- But the 2006 case was clearly too early. The bull market continued for more than 1 year.
Either way, this suggests that the bull market doesn’t have too many years left. But there is a good reason to believe that the Smart Money Flow Index isn’t as useful as it used to be.
The Smart Money Flow Index is not very useful when you look at the overall data
The above study only looks at the Smart Money Flow Index from 1982 – present. This is a classic case of cherry-picking the bearish data. We need to look at the Smart Money Flow Index’s entire data.
As you can see in the above chart, the Smart Money Flow Index fell throughout the entire 1960s while the stock market went up. Hence, this was not a useful tool for timing the stock market’s tops. The Smart Money Flow Index has a LOT of failed bearish signals.
The last hour of trading is no longer “smart money”
The last hour of each trading day has always seen heavy volume. However, trading is becoming increasingly concentrated in the last hour of trading thanks to the rising popularity of ETFs, even moreso than it was before. These ETFs need to recalibrate their components every single day, and many do so near the closing bell.
Hence, the last hour of trading is no longer dominated by “smart money”. It is increasingly dominated by algorithms and passive index funds that are neither “smart” nor “dumb”. That is why the Smart Money Flow Index dropped so fast during this correction. ETFs have a massive impact on the market’s daily close. It’s not exactly human traders and investors who are selling.
This chart shows just how quickly ETFs’ assets under management have grown.
This chart shows the spike in volume during last half hour of trading. Trading soars in the last hour not because the “smart money” is buying and selling. It soars because EVERYONE is buying and selling, dumb money included.
This chart shows how volume is being increasingly concentrated on the close.
The Smart Money Flow Index has another problem – it’s taken by using data for the Dow Jones Industrial Average. The problem with the Dow is that it’s too focused on big stocks. The S&P 500 is a much better gauge of the entire U.S. stock market because it includes mid-cap stocks as well.
The current correction has primarily been driven by a selloff in a few large stocks. That’s why the Advance-Decline Line is leading the S&P 500 higher (big selloff in a few large stocks is weighing on the average, while the majority of stocks are going up). The “smart money” is better denoted by the Advance-Decline line. The Advance-Decline line always falls before a bear market begins, which suggests that the smart money is selling during the last rally of a bull market.
Remember the adage: bull markets top on weak breadth. At the top, the smart money is selling out of their stocks (large cap and small cap) while the dumb money continues to blindly believe in large cap “story” stocks.