As hedge funds buy Apple and Pfizer, should individual investors follow?

There are many theories about investing and one of the simplest focuses on the momentum generated by big traders. Some momentum investors simply follow the smart money -- hedge funds and other Wall Street traders -- and hope to earn big returns from the stocks they love, regardless of their fundamentals. If you like the smart money momentum approach, you might want to look at Pfizer (PFE) and Apple (AAPL).

According to Bloomberg News, the smart money is plowing cash into stocks right now. Hedge funds added 21% to their stock stakes, totaling $604 billion, in the third quarter. Meanwhile, individual investors (who account for 82% of mutual fund investors) withdrew money from stocks -- pulling $37.3 billion from U.S. mutual funds since August.

What are hedge funds buying? A Goldman Sachs Group (GS) analysis indicates that Pfizer and Apple were among most popular stocks among hedge funds -- 147 owned shares in these two stocks. Pfizer is up 45% since the March 9 S&P 500 low while Apple has spiked 141%.

The latest statistics that would predict the market's direction are a jumble of contradictions. The bearish ones are as follows:

  • The trailing P/E of the S&P 500 is at a relatively high 21.9 -- suggesting an over-valued market;
  • At 3.51, the ratio of short interest to shares outstanding is 40% above the decade average, according to Bloomberg. This suggests that investors are betting on a correction.

On the bullish side, the last time mutual funds saw individual outflows this big was in the nine months leading up to February 2003, just as the S&P 500 began a five year rally.

If you look at the Price/Earnings to Growth (PEG) ratios of Pfizer and Apple, you might conclude that both stocks are too expensive to buy at these prices. Pfizer trades at a PEG of 1.45 on a P/E of 15.4 to earnings growth of 10.6% to $2.24 in 2010. Apple is a bit more expensive, trading at a PEG of 1.50 on a P/E of 31.9 to earnings growth of 21.2% to $9.43 in 2010.

Should you go with the smart money? If you do, a stop loss, which will force you to sell if your bet drops by, say, 2%, would make sense. That way, if you get trampled by the smart money changing direction fast, you will limit your losses.

Peter Cohan is a management consultant, Babson professor and author of nine books, includingCapital Rising (due in June 2010). Follow him on Twitter. He has no financial interest in the securities mentioned.

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