Our business focuses on the commodity complex. We rely on the Commodity Futures Trading Commission’s (CFTC) Commitment of Traders report to sort out what the major players are doing in the commodity markets. Our focus lies with the commercial trader category of this report. These are the traders who either have the commodity to sell or, will be using the commodity in their manufacturing processes. Following the commercial traders category, as a whole, for a given commodity can provide us with a consensus opinion from the world’s largest producers and end users of a commodity. There are times, like now, when their collective actions in the commodity markets can pay direct dividends to equity traders, both in individual stocks as well as commodity based ETF’s.
Most of our trading is based on the consensus opinion of the commercial trader group as reported in the weekly Commitment of Traders report. We track their behavior in a couple of different ways but the simple conclusion is that we want to buy when they’re buying and sell when they’re selling. You’ll see the net commercial trader position plotted in the second pane of the stock index charts, below. We measure their actions on a sum and momentum basis. This allows us to determine how anxious the commercial traders are to get their trades executed at a given price level which, in turn, tells us a lot about the importance of a given area. Obviously, the previous year’s lows are an important area. Based on the collective actions of the commercial traders across the major indices, we’ve issued a COT Buy signal.
John Mauldin recently wrapped up his annual Strategic Investment Conference and shared some insights from his illustrious speakers. In his world, the information he passed on in his summary was simply nuggets. In my world, I had to go digging for context to put it all together. As a trader, I live in a day-by-day world. As such, it’s easy to lose track of the big picture and at times, the proper context from which to view the macroeconomic landscape. Reading the notes from Mauldin’s speakers clearly illustrated two main points for my own trading.
The stock market doesn’t seem to know whether good news is good or bad news is good. The equity markets have sold off between 4 and 6 percent since we published this key reversal in early March with the small cap Russell 2000 and Nasdaq 100 tech stocks peaking a month before the big Dow and S&P stocks rolled over. April’s unemployment report supplied the catalyst for the Dow and S&P sell off but again the question becomes, “is bad news still good for business friendly easy monetary policies or, does good news mean we’re finally back on track?” Based on a number of factors, it appears the answer is somewhere in the middle. The Goldilocks equity market likes its data neither too hot nor, too cold.
This is the third cautionary report I’ve written on the stock market in six weeks. The last time I focused this heavily on the stock market was in early 2009. Back then, I was making a point to everyone who’d lost their shirt on the way down that employing the leverage provided by stock index futures contracts would be a great way to recoup some of their lost funds when the market bounced. This week, we’ll discuss the same strategy only in reverse. I’ll explain how to use leveraged futures to protect your equity portfolio ahead of time in case you haven’t taken the appropriate actions.
I thought taking a vacation at the end of 2013 might allow me to come back to the markets with a clear head and new viewpoint. My hope was that a little detachment would bring the forest back into the picture at 35,000 feet. I’ve now caught up on my reading and research and find the markets just as schizophrenic as they were when I left. While the markets remain as confusing as ever, our trip did provide me with the sense of awe that comes from physically standing in the presence of thousands of years of history. One thing is for certain; mankind always finds a way.
Back in the old days when the trading pits were full of people executing trades we had a saying, “The market always finds the orders.” This is quantified by the market through the comparison of volume and open interest levels against the price levels that generated the activity. The first rule of trend trading is that growing volume and open interest supports the market’s current direction. Last week we discussed the idea that the stock market may be establishing a late summer high with probable declines into fall from a big picture outlook. This week, we get technical.
Monday, August 5th, the S&P 500 futures traded approximately 850k contracts. Only one normal trading day in the last few years has done less volume than that. Typically, we’re looking for twice that much trading on a normal day with bigger days eclipsing the 3 million contract mark and big days reaching over 6 million like we did during the August sell off in 2011. Monday’s volume more closely matched the Christmas and New Year averages around 600k. Low volume is usually accompanied by low volatility and Monday’s trading range of was the smallest since August of last year and all the way back to April of 2011 before that. Thus, even the holidays of recent years generated more market movement.
Lower volume doesn’t always mean dying trends. There are times in a market’s trend typically, following the accumulation phase when volume will decline but open interest grows as the market begins its march in small orderly steps. Unfortunately, this is not where we stand within the equity markets’ current trend. The S&P 500 futures expire quarterly. Therefore, those who wish to maintain a position going forward have to re-establish it as their current contracts approach expiration. Those who do not may simply let their contract expire. Market participation in the futures markets is measured by open interest. Theoretically, open interest has no upside limit. As long as two new people come to the market and negotiate a trade, open interest will increase by two. One new person (long) is making a bet on higher prices going forward while the other new person (short) will profit from a falling market. Open interest in the S&P 500 futures is at its lowest levels in over a year. This means that the current market price is completely uninteresting to potential market participants.
This leads to the obvious question, “If the market is uninteresting, who’s trading?” We began to answer this question last week in our discussion of margin buying and human nature’s, “catch up” instinct. Margin buying in the stock market is borrowing money from your broker who charges you interest so that you can buy more stock than the available cash value in your account will allow. There have been four all-time highs in margin buying – 10/1987, 4/2000, 9/2007 and right now. The previous peaks all led to declines of at least one third within next 12 months. Remember the leveraged nature of the housing bubble? Leverage begets leverage…until it crumbles. Commercial traders and their large bank accounts have gladly sold all that the public wishes to purchase at these levels.
Finally, we have current technical and pattern analysis that clearly believes there is more money to be made on the expectation of downward pressure on the stock market rather than continuation of the upward trend we’ve been experiencing. One of the primary tools I utilize is the analysis of divergence. The idea is to gauge the market’s momentum by measuring various calculations against each other. The results are then plotted below the chart and we simply look for a market that has made a new high or low without a momentum confirmation. The all time highs made in the S&P 500 last week have not been confirmed by any of the popular indicators and their textbook, default settings. Meanwhile, pattern analysis shows that we have just created a broken cup with handle formation. This is a normally bullish formation gone wrong due to the currently overpopulated and leveraged speculative participation rate.
Owners of equities, mutual funds and their equivalent ETF’s should seriously take note of the warning bells. If recent history has taught us anything, we should know that six years of nowhere to new highs can be an emotionally traumatic interim. I’m not suggesting dumping the family holdings whose cost basis is now next to nothing. I am suggesting that those who’d like to sleep peacefully should look into the various ways of providing downside protection for their portfolios with advisors they trust. Insanity is doing the same thing repetitively while expecting different results. This time may be different but I’m not betting on it.
This material has been prepared by a sales or trading employee or agent of Commodity & Derivative Advisors and is, or is in the nature of, a solicitation. This material is not a research report prepared by Commodity & Derivative Advisors’ Research Department. By accepting this communication, you agree that you are an experienced user of the futures markets, capable of making independent trading decisions, and agree that you are not, and will not, rely solely on this communication in making trading decisions.
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