Trader’s Narrative

As promised in last week’s sentiment overview, here is the information and chart on the position of the retail futures traders (known as small speculators).

The most recent Commitments of Traders report covers the position of futures market participants as of last Tuesday (February 5th, 2008) and it shows that on aggregate, the small speculators are very pessimistic about the stock market.

According to data from SentimenTrader.com, the small speculators are holding just slightly above $8 billion worth of futures contracts (S&P 500, Dow Jones & Nasdaq 100):

As you can see on the chart above, this is lower than any time in the past few years. The only caveat I would throw into this wildly bullish scenario is that each time the retail futures traders throw in the proverbial towel, they do so at a slightly lower level.

The only exception to this was the low in late 2006 which was around $14 billion - above the 2003 low. And the low in 2007 which doesn’t correspond to a rally.

But after all is said and done, when we put this together with the horrible sentiment we’ve seen in the past few weeks, we get a picture of a market that is positioning for a bottom.

Well, that was something. Wasn’t it?

Simply breathtaking.

I love it when things align like that. I had to take care of some things yesterday or you would have found me gloating about this much earlier

An old saying around Wall Street is that the market moves to exert maximum pain to the maximum number of participants. If this isn’t what just happened, I don’t know what is. Who in their right mind could have foreseen what happened this week? the breakout? the sheer intensity and unrelenting buying pressure?

Unfortunately for them, those that bear the brunt of the damage tend to be the outsiders, the unwashed masses, otherwise known as retail investors and traders. For the most part, insiders make out just fine.

Speaking of insiders, the latest Commitment of Traders report, hot off the presses, shows a continuation of the same lopsided buying from the commercials. Brace yourself, because since the last report, commercials have increased their aggregate net long position by 36%.

Eventhough I was bullish as I outlined this past week, I was still taken aback by the force of the bulls. They simply demolished the bears. I don’t care what thesis a bear trots out: inflation, the dollar, China, etc… it is all meaningless in the face of such a clear and powerful breakout.

What’s more fascinating is that according to the Hulbert sentiment measures, newsletter publishers are not at all excited about the market… even as it has gone up. In fact, in the face of a rising market, sentiment has actually become less bullish. To be specific, in late February 2007, when the market was going strong (before the correction), bullish sentiment as measured by Hulbert, was 62.4%. Since then, the market has recovered the correction and then some. But newsletter bullish sentiment is now 40.6%

And Thursday’s rocket ride did not make one iota of difference! It seems like the newsletter writers out there are scoffing at the price action as merely a mirage. Who knows, it may very well be. But with history as a guide, we know that the probability of it being real is high when there isn’t much excitement accompanying market gains.

But (there’s always a but) the Investor’s Intelligence report on newletter sentiment shows a completely different picture. According to II there are 21.3% bears and 49.5% bulls. That is a fairly toxic ratio of bulls to bears. But if we look back to 2003 we see that after the bear market low was made, and as the market rallied almost continuously for the whole year, the sentiment was equally bearish according to II. So maybe history will repeat. But why are the sentiment measures so at odds?

I believe it is because Michael Burke and his team over at II use a different method to categorize newsletters. Rather than going by what the newsletters are recommending (which Hulbert does), they go by their feel of the bullishness or bearishness (or neutralness) of the newsletter after a reading. This is a much more subjective method and may account for the variance between the two sentiment measures. Ideally, we would like to see them agree with each other. But we can’t have everything now, can we?

In early June I stumbled on a promising indicator for finding market tops. As a student of the markets I’ve desperately searched for a reliable tell for tops. But for the most part the prey is elusive.

Market bottoms are much, much easier to find than tops. The VIX index pops, the put call ratio spikes, sentiment goes haywire, and on and on. There are literally dozens and dozens of indicators that one can line up as good signs of a market bottom.

The indicator that I mentioned involves the interplay between the stock market and the bond market. As the rates in the bond market rise, the stock market usually suffers because money starts to flow out of equities and into less riskier (and higher yielding) bonds. And vice versa.

It is simply, the 30 day rate of change of the 10 year Treasury Bond yield. When it approaches 9% (or more), the stock market tends to get weak. Especially when immediately prior to the signal it has been on an uptrend.

This is what we had in early June 2007 and so far, the signal has been good. I suppose we could argue whether the June high water mark is truly a “top” or whether it is simply a pause. To really know, we need more time. Still, one can’t argue that entering at that time wasn’t a good idea since it wouldn’t have made you any money. In fact, exiting to preserve capital seems to have been rather smart.

Of the major market proxies, the Nasdaq composite is the only one that has surpassed its early June highs. The Russell 2000 Small Cap index, the Dow Jones, and the S&P 500 have all traded within a range.

But I’m still rather bullish for the intermediate to long term time frame. I’ve shared with you a few reasons for that. Most recently, the remarkable Commitment of Traders report, the short interest ratio and finally the total apathy from retail investors. The fly in the ointment continues to be the flacid financials.

The latest Commitment of Traders report had a surprise inside. The “smart” money, commercial hedgers now have an all time record net long position.

If you recall I’ve mentioned the Commitment of Traders Report a few times and pointed out the aggregate net position of the commercials.

The usual behaviour for commercials in a rising market is to either reduce a net long position or to increase a net short position. After all, they are commercial players who already have exposure to the stock market which they want to hedge.

But something quite singular has unfolded recently. Since around April 2007, eventhough the market has gone up, the aggregate nominal value of the commercials has been net long. And it has remained net long over a prolonged period of time.

Now, it has actually increased remarkably and broken all previous records. The aggregate nominal value of the commercials net positions is a historic $14 billion (appx.).

And it is even more remarkable when you consider that not only have the markets been rising lately, they are either in or almost at, all time highs.

As I look across at the internal metrics and various indicators, most are ambivalent or neutral. The COT is by far the most bullish one out there right now. However, I do want to point out that with this sort of indicator, which is dealing with dollar values (of contracts), we have to be careful.

Over time, the market tends to increase in size, capitalization, and with it commensurately, volume and trading activity. If we compare today’s market, on a dollar basis to itself, say 5 or 10 years ago, we are comparing apples and oranges. This is why stock market activity is usually equalized using GDP or other economic gauge.

In the same way, the COT data I mention above is in dollar terms and therefore, we have to take it with a grain of salt. The fact that it is now at a historic extreme may not be due to simply an extreme in sentiment but in the increasing size of the market and contracts traded.

But while we consider that caveat, there is no doubt that the picture it paints over an intermediate time frame is still quite bullish.

On April 25th 2007, I wrote that gold bulls would be disappointed (again). Lets take a look to see what happened since then and what we can tell for the sector going forward.

I pointed to the Commitment of Traders report, which showed the “smart money” commercials being markedly net short. Since then that lopsided situation worked itself out.

On April 17th 2007, the commercials position was: long 79,882 and short 254,480, which is a net short position of 174,598 contracts. From the previous week (April 10th 2007) the commercials had reduced their longs (-7,564) and added considerably to their shorts (+13,830). Meanwhile, the small speculators were long 54,973 and short 15,733, for a net long position of 39,240 (on April 17th 2007).

Now compare that to the COT on May 29th 2007. The commercials had a long position 125,989 of and a short position of 244,684 for a net short position of 118,695 contracts. And the small speculators were long 57,428, and short 33,630 for a net long position of 23,798 contracts.

An important metric to watch for the COT is the open interest. Currently it is at 425,688 contracts, a 12 month high. Usually important changes in trend develop when the market is positioned lopsided (commercials vs. speculators) and when the open interest reaches significant levels. We saw this happen in late February 2007 where the commercials had been increasing their net short position while the small and large speculators were going more more long. With the open interest at around 415,000 contracts, things hit their climax and it started to unwind.

As well, the Rydex sentiment measure was flashing a caution sign. Considering also that the gold index fell to an area of previosu support, it wasn’t surprising to see it rally last week. It started with hammer on Wednsday and then two back to back long range up days:

Last week may have gotten the gold bugs rejoicing. But when you step back and look at the larger picture you see a very lackluster performance. Relative to the general stock market, the gold sector has lagged significantly. It is stuck in a wide trading range and is no where near break out levels. If it does approach the 370 level without looking too overbought and if the k-ratio is low enough, then I might change my overall outlook on this sector.