The Smart Money Is Buying Equities. The Dumb Money Is Buying Bonds.

The VIX is telling us that the ‘smart money’ is buying equities, however the flow of funds data tells us that the ‘dumb money’ is buying bonds.

Reading the VIX

Since the beginning of October last year the VIX Volatility Index [VIX], often referred to as the fear gauge, has been falling. The VIX reflects the options activity on the Chicago Board of Options Exchange (CBOE) and shows how the smart money (option traders) are betting on the S&P 500 over the next 30 days. Christian DeHaemer over at wealthdaily.com provides the following example:

“If the VIX is 15, this represents an expected annualized change of 15% over the next 30 days. Thus one can infer that the index option markets expect the S&P 500 to move up or down 15%/√12 = 4.33% over the next 30-day period.”

A 1 Year Chart Of The VIX Volatility Index [VIX] Chart courtesy of Stockcharts.com

Today the VIX is 15.57, down from 46.88 on 4 October 2011, indicating that the option traders doesn’t think that a major correction is imminent, i.e. they can’t make money buying put options. This tells us that the smart money is buying equities – something which is confirmed by their recent performance.

The Flow Of Funds Data

According to the Flow of Funds data, retail investors, sometimes referred to as the dumb money, continue to pour money into bond funds. High yield, emerging markets, municipal and mortgaged backed bond funds have been the main beneficiaries as investors spurn stocks.

Retail investors seem unaware that the bond market is in a bubble and is nearing a major (multi-decade) top. Investors entering the bond market not only face the likelihood of significantly lower bond prices in the years ahead, they are also exposing themselves to massive potential counter-party risk. Not to mention the fact that the returns they are getting are for the most part deeply negative when adjusted for the rate of inflation.

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