On November 8, 2010, the venerable Wall Street Journal declared the “Dumb Money” had returned to stocks.

And unless you run a mutual or hedge fund or otherwise have access to the advantages of institutional buying… you are the Dumb Money.

The comment was based on an American Association of Individual Investors weekly sentiment survey showing 48% of investors were bullish on stocks. That was a little over two months ago…

Then this week, the same weekly sentiment survey showed 56% of individual investors are bullish on where the market will be in six months, leading Barron’s to pronounce:

If the dummies are all excited about the market, it is a red flag of caution.

A few things about this…

It’s spot-on

You can call this notion a lot of things — mean-spirited, callous, the epitome of Wall Street greed and elitism — and you’d be right on most counts.

But that doesn’t take away the fact that, objectively, the “Dumb Money” idea has merit.

The last time retail investor sentiment rose this high was late last spring, and the Dow quickly plummeted more than 1,000 points:

Now here we are, the Dow on an unchecked 1,700-point rise… and the Dumb Money is getting giddy again.

I’ll give you one guess what happens next…

I can picture the fat cats at Goldman trying to load a few more laypeople on the ship before they crack the hull.

When you put it like that…

Think of it like that game of push-a-coin at your favorite childhood arcade…

All those quarters, just dangling there on the edge. All you have to do is time it right, and they’re all yours. And the more quarters that pile up close to the edge, the easier you think it is to win…

That’s exactly where the market is right now. More and more quarters are piling up on the edge, and none have fallen off yet.

The Dow has been on an upward march since October.

Just like kids line up behind push-a-coin machines with lots of quarters on the edges, individual investors are now lining up to feed money into a stock market they think is only going higher.

Cutting in line

Thing is, the stock market’s a bit more complicated than your neighborhood arcade.

In the market, the entire tray of quarters can be cleared by the time you drop your money in the machine — just like in May, the last time investor sentiment was this bullish, when the Flash Crash occurred and the Dow sank 998 points in one day.

Now I’m not saying the game is rigged. I’m just suggesting the deck isn’t stacked in your favor.

Take the official reason given for the Flash Crash by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). It said the market was:

“so fragmented and fragile that a single large trade could send stocks into a sudden spiral” and that against a “backdrop of unusually high volatility and thinning liquidity a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 E-Mini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.”

I know that’s a bit complex. But ask yourself just one question:

When’s the last time you had access to a “sell program” that could execute $4.1 billion worth of trades in minutes?

You never have. And neither have I.

That’s the point here.

You’re not vying against youthful competition for your turn at a bunch of quarters; you’re up against mutual funds, hedge funds, and banks that have complex computer algorithms telling them exactly when the quarters are going to fall.

And they don’t have to wait in line for their turn…

They can sell at any time — even while you’re queuing up a large buy order — executing millions of trades in matters of minutes, buying and selling twice before you log in.

The computers are programmed to sell when they think all the Dumb Money is in.

The collective Wall Street is the conductor of the Dumb Money train. Its only destination: lower middle class.

Sheep in a swan contest

John Maynard Keynes (from whom we get Keynesian Economics) partially noted this phenomenon back in 1936 when he described the stock market as a unique beauty contest.

In his beauty contest, stocks were like women’s faces. But you’re not supposed to bet on who you think is the prettiest, you’re supposed to bet on who everyone else thinks is the prettiest.

Keynes described it as devoting “our intelligences to anticipating what average opinion expects the average opinion to be.”

Average opinion thought all stocks were headed higher in the 1920s. Average opinion thought dot-com stocks were going higher in the early oughts. Average opinion thought mortgage-backed securities were headed higher a few years ago.

Only now, Goldman anticipates the average opinion of Dumb Money with software written by MIT grads.

To avoid having the rug pulled out from under you, you have to make a concerted effort to not be the Dumb Money. That’s easier said than done, given the fact that being a retail investor inherently puts you at a disadvantage.

If you want to make money in today’s market, you’ve got to have contrarian qualities.

Don’t chase the Dow on the way up. Be wary of the blue chips at 52-week highs. Buy stocks the big boys aren’t manipulating.

Put to good use the inevitabilities of the next few decades that governments and media won’t admit to the masses…

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  the rising costs associated with feeding 6.9 billion mouths and counting

  
  
  


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  the impact of water shortages affecting 2 billion

  
  
  


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  the unsustainability of the American consumerist lifestyle, and the immense debt it’s created — both public and private

  
  
  


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  the eventuality of Peak Oil and what it means for all forms of energy

  
  
  


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  the realization the U.S. military/industrial complex has become too large

  
  
  


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  the acknowledgement the United States is ill-prepared to compete with BRIC nations for low-wage jobs

  
  
  

Use these for personal profit as they play out.

That’s a good start to shedding the Dumb Money label.

That’s what Energy & Capital editors think about every day…

It’s the only way to come out ahead against machines compiling zettabytes of data about how retail investors behave, and use it to steal your quarters before you even make your play.

Call it like you see it,

Nick