The "Dumb Money Confidence" index rose to its third-highest reading in 25 years on Friday, just as the VIX volatility index, also known as Wall Street's "fear gauge" traded at its lowest levels since 2019.

Coincidence or correlation?

It's a well-known maxim of Warren Buffett: "When everybody else gets greedy, get scared. And when everybody else gets scared, get greedy," and illustrates perfectly what the two indexes are telling us: that the bandwagon effect has taken hold.

The bandwagon effect, follow-the-crowd — whatever you want to call it — is a trading bias that indulges a group-think mentality. This would be fine if you follow a crowd getting in on the meat of an asset price rise.

Following The Crowd Too Late

But bandwagons don't pick up the players until the tune is well established. And so it is with dumb money that follows the trend too late.

That, according to Jason Goepfert, founder of Sentiment Trader, who invented the Dumb Money index, is why stock indexes are trading within 2% of their record highs, why the VIX index, a measure of market confidence, is trading at a four-year low and his own index is at its third-highest level in 25 years.

The time most trend-followers hop on a trend, and most aggressively, is about the time the trend is becoming exhausted," says Goepfert.

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," he adds.

The Dumb Money index is currently at 87. When it hit 88 in July, the S&P 500 suffered a three-month pullback.

How Far Can the Rally Be Pushed?

The current rally in stocks has been established for nearly two months so it could have longer to go — particularly given the boost this week from a more dovish than expected Federal Reserve.

Goepfert says: "Very high confidence typically precedes modest gains at best until sentiment resets."

Much will depend, going into 2024 on the macroeconomic environment, which is already showing signs of slowing growth.