Stock market © Digital Vision Ltd., SuperStock

On the face of it, things couldn't be better in the stock market. And the average American is feeling pretty good about that. It's easier to judge the economy by where the Dow Jones Industrial Average closes than by looking deep into boring economic data.

But to Wall Street's inside operators, the hedge funds and proprietary traders that always seem one step ahead of the masses, things don't look so right. In fact, according to a mix of indicators from mutual fund flows to options activity and futures positioning, insiders are starting to sneak away just as Main Street investors are jumping in.

You can see where this is headed. Emotions run high, greed clouds judgment and the market gets more and more overextended. When this party ends, everyday investors will be left holding the bag.

The professionals have been spooked by something, which is why they're running for the hills. They have good reasons to run. Here's what they see coming, and how I'm investing for that reality.

Running for the exits

Now, I've been skeptical of this rally for months for many reasons. Breadth wasn't there, as many stocks were left out. Leadership wasn't there, as dividend-focused utilities, health-care and consumer staples stocks led the way. The fundamentals weren't there, either, in company numbers or the economy.

But none of that has mattered, because the market will do what it does. If people want to own stocks badly enough, the market could double in the midst of a depression. This rally all comes down to emotion, fueled by cheap money from central banks, and that can keep it running for quite a while. I didn't appreciate that reality enough.

But I'm ready to call this what it is: a market bubble, where euphoria pushes out reason, the hard data are ignored, and the so-called "dumb money" buys from the "smart money" folks at the market top.

Take a look at the chart below, which tracks this phenomenon and which I'll explain. And yes, "dumb money" may be offensive, but it sums up what Wall Street thinks of a lot of its customers.

SentimenTrader Smart, Dumb Money Index

SentimenTrader's Smart Money/Dumb Money Confidence Index tracks what the insiders are doing versus what average investors are doing. The "smart money" measure includes things such as option put/call ratios, commercial hedge positions in the futures market and the relationship between stocks and bonds -- all keys to figuring out the Wall Street pros' moves. The "dumb money" measure includes things such as fund flows into Rydex mutual funds and activity by small speculators in equity index futures -- indicative of moves by more average investors in 401ks and retirement accounts.

Combine the two and you get the telling indicator shown in the chart above. When the number falls, average investors are acting with far more confidence than the pros on Wall Street. They are buying while those on the inside are selling.

The "smart money" measure has dropped to levels not seen since market tops last September and last April. The "dumb money" confidence measure has soared to levels that were also last seen during that time. What followed those months were multi-month market corrections. Likewise, peaks in the chart -- such as early 2009, mid-2011 and mid-2012 -- were associated with great buying opportunities in the market ahead of long, low-risk uptrends.

In fact, the chart above shows how the combined measure has been a solid indicator of future market performance since the 2009 bear market low.

What's happening now is that Wall Street insiders are bailing out. It remains to be seen if they are moving ahead of a small, 5% correction or something much worse, but they see something bad coming.

Now, this measure could clearly continue to drop deeper into extreme territory while stock prices keep pushing higher. The timing on this is far from clear. But what's changed is that the bubbly nature of this market is being laid bare as prices increasingly disconnect from reality.

Stock gains just aren't enough

I can't say this surprises me. The "wealth effect" of higher stock prices -- the belief that higher portfolio values would boost stagnant consumer spending and revive stalled economic growth -- was always a fantasy of the market bulls.

In other words, the experts in Washington and on Wall Street have believed higher stock prices would create their own fundamentals, lifting the economy with them. They haven't. Corporate profitability is declining as the ratio of negative versus positive Q2 earnings preannouncements increases to levels not seen since 2001. Corporate executives are trying to lower expectations. And various economic indicators are increasingly missing expectations, as illustrated by the chart of the Citigroup Economic Surprise Index below. (The index falls when economic indicators miss expectations, and rise when the numbers are better than expected.)


Why hasn't this strategy worked?

The experts have ignored the fact that fewer and fewer Americans are even participating in the market, despite the 150% bounce in the S&P 500 off of its bear market low. A recent Gallup poll finds that U.S. stock ownership remains at records lows, with just 52% of adults in the market versus 65% at the 2007 high.

They've also ignored this undeniable truth: In inflation-adjusted terms, the stock market is still below its 2007 peak, which in turn was below the 2000 peak. In that perspective, recent gains in real terms don't mean much.

This strategy also only widens the gap between the rich and the poor -- the root cause of the credit bonanza and mortgage-equity withdrawals that fueled the housing bubble -- since the ultra-wealthy own the vast majority of financial assets. According to G. William Domhoff at the University of California at Santa Cruz (read his report here), the bottom 80% of Americans own just 4.7% of all financial wealth; the top 1% control 42%.

Those experts also ignore that, as pointed out by Morgan Stanley's Gregory Peters, the wealth effect only works when it lowers household savings by raising spending. But with the savings rate at just 2.7% as the household debt-to-disposable-income ratio is still north of 120%, people haven't yet rebuilt their balance sheets after the mid-2000s housing bubble/credit explosion. They aren't in a position to spend.

And that the positive economic tailwind from higher stock prices and housing prices has diminished since the 2007-2009 wipeout. Sensitivity to housing wealth -- or how likely it is that an increase in housing wealth will encourage new consumer spending -- has fallen roughly 35%, while sensitivity to stock market wealth, which is much smaller anyway, has fallen 27%.

Blowing bubbles

Not only has this drive to raise stock prices not fixed the overall economy, it's sowing the seeds of the next crisis.

It's happening because Washington wants it, with record highs in the stock market being one of President Barack Obama's only true, unarguable economic accomplishments. (He acknowledged recently that the job market is still "challenging" while housing remains well below peak valuations.) And of course, Wall Street wants it because it means trading revenue, bigger bonuses and increased market liquidity. It's easier to trade in and out of big positions, or milk pennies with predatory computer-trading algorithms, when Main Street investors are throwing in, too.

Thus, dovish leaders are elevated at the Federal Reserve -- with dovish Fed Vice Chairwoman Janet Yellen likely to replace Ben Bernanke next year -- as the central bank pumps trillions into the banking system and effectively finances the federal deficit while Wall Street piles its idle cash into U.S. Treasury bonds instead of investing to grow.

Image: Anthony Mirhaydari - MSN Money

Anthony Mirhaydari

And all the while, regulators and politicians turn a blind eye to the unresolved "too big to fail" problem as the major banks just keep growing, like a cancer. Just look at the total assets at Bank of America (BAC); they've swelled from $1.5 trillion in 2007 to $2.1 trillion now. Wells Fargo (WFC) assets have gone from $550 billion to $1.4 trillion. 

No one wants to shake the boat. Wall Street is actively fighting any effort in Congress to rein in the big banks, and the rising market is giving lawmakers an excuse for inaction.

The bankers know the bigger they get during the bull market, the safer they'll be in the next downturn since taxpayers will have no choice but to support them. No need to worry about the sting of failure and bankruptcy.

And according to comments from Attorney General Eric Holder back in March -- comments he's since tried to walk back -- the CEOs leading these monstrosities have become too big to jail for fear of damaging sentiment and shaking markets. Both would be bad for politics heading into the 2014 midterm elections.

It won't work in the end, but. . . 

Despite the hard reality of all this, herd mentality and a lack of attractive alternatives has everyday investors piling into stocks at a dangerous time. And, as I've said, this could keep pushing the market up for a while.

You don't want to be left out if the market insists on going up. But as I told investors at the Las Vegas Money Show last week, this is no time for buy-and-hold complacency, because change is coming.

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So here's what I'm doing.

With the market going into full bubble mode over the past few weeks, I've tightened my focus to short-term breakout stocks like AMD (AMD), LDK Solar (LDK), Mechel (MTL), James River Coal (JRCC) and Nokia (NOK) to participate to the upside in a way that controls risk. Get in, hold for a week or two, and then get out.

Coal stocks, which I wrote about a few weeks ago, continue to break out, with the Market Vectors Coal ETF (KOL), Talisman Energy (TLM) and Peabody Energy (BTU) all looking good. I've highlighted this in the Peabody chart below. And I've added all three to my Edge Letter Sample Portfolio this week; you can view it here.

Peabody Energy Corp.

Annaly Capital Management

Short opportunities are also popping up, a consequence of the selling pressure beginning to enter back into the picture. Just look at the way Fed-dependent stocks like mortgage REITs Annaly Capital (NLY), Anworth Asset Management (ANH) and Armour Residential (ARR) are rolling over. Someone obviously believes the Fed will pull back from its purchases of mortgage-backed securities, that mortgage rates are about to increase or that the housing market is about to weaken. All three would be negatives. I've added NLY and ANH short to my holdings as well.

No matter how you come down on the bull versus bear debate, just keep in mind the genesis of what we're witnessing, the changes that are happening under the surface, and manage the risk in your portfolio accordingly. Don't be complacent. And don't believe for a minute that this is a rally built on true fundamentals.

It is, like the housing bubble, supported by easy-money Fed policy, lax regulatory oversight, raw excitement and the implicit backing of the powerful in Washington and on Wall Street. And as its true nature is revealed, insiders are growing increasingly nervous.

At the time of publication, Anthony Mirhaydari did not hold positions in any equity mentioned in this column. He has recommended NLY and ANH short and KOL, TLM and BTU long to his clients.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.