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.

This past week we didn’t really see any significant change in the usual sentiment measures:

LowRisk.com, which was showing a very lopsided bearish opinion (59%) mellowed out as some bears moved over to the neutral camp, reducing their numbers to 44%. Meanwhile, the bulls remained almost unchanged (38%).

Even less change happened in the Investor’s Intelligence survey with neither bulls (41.6%) and bears (32.6%) really budging from last week.

The Consensus survey continued to drop this week reaching 25%. We haven’t seen this measure this low since the summer and winter of 2004. Just a few weeks ago Consensus bullishness was at 47%.

For those unfamiliar with this survey, a little background: Consensus aggregates the sentiment and recommendation of several hundred analysts and independent advisory services. If I don’t mention it, you can find it each week buried in the bowels of Barron’s.

Although it is now at a multi-year low, during the aftermath of the 9/11 terrorist attacks it reached as low as 10%. I don’t think it is fair though to ask that it plumb those depths again in anything but extraordinary market circumstances.

The CBOE equity only put/call ratio back off the Tuesday (February 5th, 2008) high of 0.95 to finish the week at just below 0.80 - elevated levels of concern but not really panic.

The only other noteworthy event is the position of the retail futures traders. But this isn’t really a sentiment measure so much since they have already “put money where their mouth is”. I’ll go into the details for it on Monday. See you then.

I received a lot of questions regarding my post on the extremely bullish commitment of traders report. So let me explain it and answer the questions that were raised. Then I’ll cover the most recent COT report and its significance.

What is the COT?
The Commitment of Traders report is a static snapshot of how the 3 different market participants (commercials, large speculators and small speculators) in any futures market are positioned. Each week the Commodity Futures Trading Commission (CFTC) reports how many contracts each of the three are long and how many they are short. The classical viewpoint is that commercials are the savvy group with inside information (who knows more about gold than a mining company?) and the small speculators are the ‘dumb money’ easily panicked by fear and lured by greed.

But interpreting the COT is as much art as it is science. It not only provides an amazing snapshot of the make up of the market, with each participant’s net position explicitely laid out but it also is a treasure trove of historical information. However, you have to navigate the data with a very nuanced approach.

There are a few details that can throw you off course. For example, the threshold for what is considered a small speculator as opposed to a large speculator can and has changed over time. And how reliable is it if a contract lot of, say, 990 is considered ’small’ but just 10 more is considered ‘big’?

There is a lot of information on the web if you google the term and some variety of words like trading, signal, bullish, bearish, etc. If you’re totally new, read up on the vocabulary so you know what the terms mean. And then from there move to the more advanced stuff.

One great new source of COT data as well as actionable trading information is the blog COTs Timer, written by fellow Canadian Alex Roslin. As opposed to my mish-mash, back of the napkin methods, Alex does thorough backtesting.

How bullish?
Now, on to the current COT data. The latest report shows another record setting bullish position by the commercial traders. They are now holding their largest aggregate net long position for the past 7 years. I think this is where a lot of the confusion came from in my last mention. Many thought that I was talking about one specific contract rather than the group of equities futures contract (in aggregate).

This is significant when you consider that the usual net position for commercials is to be short equities. Since they already have exposure to the market by the very nature of their business, they naturally want to hedge that exposure by going short the futures. So for them to even eliminate a net short position, that is be neutral, is quite a bullish sign.

But for them to actually go net long… well, that is a rarer sight indeed.

The SS Queen Mary
So while right now the commercials are net long for the S&P 500 minis they are not so for the larger contract. While this sort of ‘conflicting’ data can seem confusing, if we look at an aggregate number, rather than an individual futures markets we get a more holistic view. This market ‘gestalt’ can be useful in setting up an over arching view of the market.

While the put/call ratio or the LowRisk sentiment survey can be like zippy little speed boats, this aggregate view of the COT report is more like the SS Queen Mary. Can’t turn on a dime. But when it turns, boy, does it have an astounding amount of power behind it.

That reminds me. I have to do a better job of pointing out and categorizing the various market indicators mentioned. Otherwise it can be really confusing:

I’m bullish on the markets from an intermediate to long term perspective, but I do think that we are seeing a bit of an over extension here which warrants caution.

Now that I’ve said that… watch the market zip higher!

The Commitment of Traders (COT) report is issued by the Commodity Futures Trading Commission (CFTC) and shows how small speculators, commercials and large speculators have placed their chips in the futures markets.

In contrast to other indicators like sentiment, it is an invaluable source of market information because it objectively lays out how the three separate players are positioned. The only caveat is that it comes with a 3 day delay (so insiders can still have an edge) so by the time you look at the target, it may have already moved.

Nonetheless, as long as our time horizon is medium to long term it can still be useful.

The latest report COT was released last week on Friday May 25th 2007. It showed a remarkable change in the behaviour of the commercial hedgers (known as the “smart money”). They not only reversed their recent short run bet against a rally, but are now sitting on one of the largest aggregate net long positions in the past 10 years.

The S&P 500 COT report shows the commercial hedgers as net long as they were in the early part of 2003 while the “dumb money” small speculators are still as short as they were at the March 2007 market bottom. In short, they are equally bearish even as the market has shaken off the dip we had in late February and early March 2007.

Over at the Russell 2000 (the small caps) things are quite lopsided as well. The small speculators are net short as much as they were at the bottom of the market in the summer of 2006.

Here are a few examples of previous times the commercial hedgers were close to this net long:

October 2005
January 2004
March 2004
May 2004
September 2003
August - October 2002
September 2001

With the exception of the 2004 instances, this was a fantastic tell that the market was headed up (on an intermediate to long term time horizon).

It is unusual to see such a lopsided bullish position by commercials after the market has risen considerably. Usually they step in and scoop up the market when it goes on sale due to panic selling (September 2001, for example).

I would be more confident buying along with the commercials when the market has been spooked lower but under any circumstances, it is too risky to bet against them. That is what you’d be doing if you short this market right now.