There are two situations that lead to big events in the markets and they represent psychological mirror images of each other. The first issue is overconfidence. Whether this is overconfidence in a market, a strategy or one’s self, overconfidence leads to carrying the largest position at the most inopportune moment. The second issue is indecision. There are times when a market approaches critical levels yet; the trading population appears uninterested or, scared. Either way, indecision leads to fewer participants while overconfidence leads to too many. Therefore, our focus today is the examination of a very bullish net commercial trader position in the face of the lowest commercial participation rate since the economic collapse of 2008-2009.
It sure seems like everything in the news has been full of alarm bells lately due to Greece, China and falling oil prices in one form or another. Frankly, China’s impact on the US equity markets may be just the buying opportunity we’re looking for as several factors combine to point towards strength through the expiration of the September Dow Jones futures contract on September 18th.
I understand that our weekly readers may feel like we’re beating a dead horse over the last few weeks. We’ve stated and re-stated various reasons for our concerns regarding the equity markets and this week has provided yet more fuel for the warning signal. First of all, let me begin with my personal bias by stating that, as an S&P 500 pit trader whose only decade on the floor was the 1990’s, I’m used to making money on the long side. However, there are enough warning signs in the marketplace right now that I won’t take a long position home. I believe the next home run trade in these markets will be on the short side and this week, I’ll provide one more big money example.
There are times when the markets tell us more about what’s going on than the people on TV. I think this is one of those times. The recent rhetoric has been a political budget argument over nickels and dimes when we they need to be talking about hundreds and thousands. The political blame and spin game is being played at its highest level. The reality is that we are quickly approaching the end of the second round of quantitative easing. The government’s balance sheet reached a record level of $2.63 trillion as of April 7th. This is evidence that the fed has been putting their purchasing power to work. The $600 billion that was enacted to keep interest rates low, provide loans to new businesses and help the economy regain its footing after the financial meltdown of ’08 may be coming to an early end. The markets suggest that the Fed’s next meeting on April 26th could put a kink in the free flow of dollars coming to the market.
There are arguments on both sides of this fence from the insignificant periphery right down to the board of governors itself. The quantifiable portion of this argument is that the commercial traders clearly expect a slowdown in inflation and the economy in the near term. The consensus and conviction of the commercial traders’ positions can be seen in multiple markets; corn, oil, heating oil, copper, bonds, 10 year notes, S&P 500 and Dow Jones futures, etc. Their shift in positions can best be described as, “defensive.”
Copper is typically referred to as the, “economist” of the metals markets. Its use in building construction has always been a fair barometer of the economy’s growth and contraction. Commercial traders in copper from the commitment of traders report have shed nearly 40% of their positions since late February. The combination of China’s successive rate hikes and tightening lending practices paint a clear picture that their fully stocked warehouses are in no danger of depletion.
The crude oil market has seen consistent selling by commercial traders above $100 per barrel. Fear, due to the unrest in Northern Africa has been the primary driver of crude oil prices. This market has remained oblivious to the fact that the storage wells in Cushing, Oklahoma are bumping along near record levels. The price of gasoline has disconnected from the price of crude due to refining issues, not supply issues.
Interest rate futures have seen a flush of commercial buying. The 10 year Treasury Notes have seen commercial positions increase by more than 20% while the 30 year bonds have seen commercial traders increase their net position from 70, 000 contracts at the end of February to more than 120,000 contracts currently. Their buying of U.S. interest rate futures is part technical, and part predictive of a flight to safety driving down Treasury yields.
The flight to safety is predicted from commercial traders selling stock index futures. Commercial traders were buyers on the mid March stock market correction. However, their buying was light and their selling since has pushed their net momentum to negative levels. They may view the extended period of low volatility in the VIX index combined with testing the markets’ February highs as reasonable long liquidation levels or, low risk short selling opportunities.
This combination of moves is certainly bearish. I believe it is predicated by the theory that QE2 may be brought to an early end. If this is the case, the short term reaction would be a stronger U.S. Dollar. This would obviously be a short term negative for commodity markets in general like copper, oil, grains, cotton, etc. However, this would do nothing to alter the global change in demographics. There will be no fewer people to feed and this will not impact the growing global purchasing power that has fueled much of the commodity rally. Therefore, the macro trends will remain intact. This will simply force out many of the weaker hands that have been riding the coat tails of the rallies on the way up.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.
Volatility’s Perfect Storm
I’ve been actively trading the stock indices – S&P 500, Nasdaq, Russell 2000 and Dow futures for 20 years and I’ve never seen a day like today. It was truly a, “Perfect Storm.” I believe this will happen more and more frequently in the future as the three main reasons for May 6th’s volatility are gaining momentum all of the time.
First, public complacency was the highest it has been since the summer of 2007. Every bailout and new government program bolsters the warm and fuzzy investor psyche that allows us to believe everything will work out. The Volatility index measures the cost of protecting your stock portfolio through the purchase of put options. Put options are like buying portfolio insurance. If you hedged your $300,000 stock portfolio it would have cost you approximately $8,500 in put premium to protect the full value of that portfolio through June, from any downside risk. That same insurance policy in the afternoon would have been worth $23,625. Considering the value of your portfolio equaled the decline of the stock market, you would’ve lost 3.25% on your $300,000 or, $9,750. The difference between the $8,500 paid up front versus the current portfolio’s value of $290,250 plus the current value of the insurance policy $23,625 means that your net worth on the stock market’s biggest point loss day in history would have actually INCREASED by $5,375. The increase in the VIX is the reason for the inflated option premium and the magnitude of the rally of the VIX bears testament to the market’s general complacency.
Secondly, All of the markets are tied to each other. That’s why we are Commodity AND Derivative Advisors. In the age of electronic commodity trading, one issue always affects another one and that one in turn, affects another on and so on. Every trade in an outright market like the S&P 500, Euro Currency or, Japanese Yen will have an effect on the other markets related to it. This has, in effect, created one giant butterfly effect. In the age of algorithmic trading, where the minutest of market inefficiencies are exploited by aggressive capital placement, abnormal market moves will become self fueling. Many of these models use markers based on the model’s expectation of, “normal,” relationships to its data points. When things get pushed beyond the model’s, “normal,” expectations you have a case of, “If you liked stock ABC at $12 a share, you’re going to love it at $4 a share.” There were at least two stocks in the S&P 500 that traded to 0, today. This means they were broke, bankrupt, didn’t exist. Two Fortune 500 companies disappeared on someone’s lunch break and by the time the employee got home from work, no one knew the difference. Twenty minutes of electronic market butterfly effect.
Finally, as the market began to fall, the media was showing the Greek police force in full riot gear after passing their severe austerity vote in an attempt to procure financing from the European Union. Furthermore, the context of the day’s discussion among the talking head TV pundits was the doom and gloom surrounding the demise of the European Union, civil protest and bankruptcy in Greece with the specter of Spain’s impending default as a backdrop. Doom and Gloom sells. Traders, both retail and institutional are listening to the end of the world as we know it while watching the stock market meltdown and trading programs are ticking off one sell order after another in an attempt to be the first ones to market with their orders. The pursuit of greater bandwidth on their data feeds, faster processors in their computers and deeper levels of quantifiable algorithms put them in the lead in the race to the bottom and right back up. Welcome to the new age of 24 hour doom and gloom media coverage, total connectivity and computer programs replacing common sense trading. We specialize in common sense trading.
This methodology is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. This method is meant for educational purposes and to illustrate the correlation between the commercial’s trading and its effect on creating turning points within the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures. The information contained herein comes from sources believed to be reliable, but are not guaranteed as to accuracy or, completeness.
This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk in investing in futures.
Today’s price action appears to have trumped the
deflation/reflation argument that has been building over the last month. Many
of the markets have been rallying on small speculative buying as seen in the portfolio
rebalancing by the major long only funds.
Looking at the Commitment of Traders reports over the last
few weeks, we can see an increase in the net long positions of small
speculators in the following markets:
Swiss Franc, Japanese Yen, Canadian Dollar, Unleaded Gas,
Wheat, Beans, Bean Oil and Meal, Corn, 10yr. Notes, Eurodollars, Live Cattle,
Hogs, Copper, Orange Juice, Coffee, Sugar and Dow Jones futures.
The commercial hedgers have gladly stepped in to take the
short side of these trades with their numbers building as we’ve neared the
October – November resistance in many of these markets. Obviously, the interest
rate sector is the exception, although, there is strong short hedging taking
place at these levels.
There are a few major reasons for the resistance at these
levels. First, the U.S. Dollar Index has a strong bias towards setting a high
or low for the coming year in the first two weeks of January. If the Dollar’s
trend is going to be higher, the global demand for American commodities will
decline. Secondly, portfolio rebalancing by the major index funds for 2009 is
going to balance smaller gold weighting against heavier crude oil weighting.
Today’s collapse in crude oil futures is an indication that they may have filled their
need for crude. This also helps explain Gold’s inability to rally through $900
even on weak U.S. Dollar days. Lastly, the economic numbers continue to get
worse with each release. Last week’s ISM numbers were the worst since 1980.
Unemployment this Friday should continue to rise and eventually head north of
This is a very brief outline of the weakness I’m expecting
in many markets in the near term. Please call with any questions.