With the first quarter in the bag and the stock market at new highs, I wanted to recognize and analyze a couple of interesting divergences that are developing among what I would consider smart money investors, and may be telling a different story that what you are hare hearing from media pundits and Wall Street strategists.
With speculators maintaining record long positions in the S&P 500
(INDEXSP:.INX) e-mini after being short for most of the rally off the 2011 lows, it’s pretty clear to me that underexposed hedge funds are behind this parabolic advance. Hedge fund investors might even have to dole out performance fees this quarter to managers who were only now just able to catch up to their benchmarks. In order to keep the party going the specs are going to need others to hop aboard the train, and as I pointed out last week in QE Correlation Does Not Imply QE Causation,
I thought the opposite was happening:
This change in positioning is very important because, as evidenced by the increase in volume since the beginning of the month, I believe there has been a big shift in ownership of this market from real money into levered accounts.
ES COT Large Speculators Net Position
Clearly the 1550 area is bringing out the big sellers and the buyers have exhausted a lot of ammo in order to absorb the supply. Considering the recent spike in speculator positions I believe the levered money is trying to defend this 1550 level. The question for the future direction of the market is whether they have the bullets left to take the market higher.
It’s not just speculative positions that point to this change in equity ownership it can also be identified in the relationship between Bloomberg’s Smart Money Flow Index and the Dow Jones Industrial Average
The Smart Money Flow Index is calculated by taking the action of the Dow in two time periods: the first 30 minutes and the close. The first 30 minutes represent emotional buying, driven by greed and fear of the crowd based on good and bad news. There is also a lot of buying on market orders and short covering at the opening. Smart money waits until the end and they very often test the market before by shorting heavily just to see how the market reacts. Then they move in the big way.... Whenever the Dow makes a high which is not confirmed by the SMFI there is trouble ahead.
Smart Money Flow Index Vs. DJIA
According to Bloomberg’s calculations, the so-called smart money investors were the most exposed last September and have been fading this most recent leg of the rally. The ratio of the DJIA/Smart Index is at the widest since the 2009 low, pointing to a clear divergence in smart money participation as the Dow hits a new high. Of course, this in and of itself does not mean stocks are topping and divergences can continue for long periods of time, but I think it does help support my thesis that the ownership has changed from strong real money into weak levered money hands. With hedge funds now in charge of the stock market it remains to be seen how they will conduct themselves as we embark on the second quarter and into the summer which have been seasonally weak since the 2009 low. In fact we saw similar hedge fund buying in the first quarter of 2010 and 2011 that both preceded nasty corrections. If history is any guide they are quick to head for the exit at the slightest hint of a change in momentum, and it’s not clear where the smart money bid comes back in to absorb what is a large supply of levered longs.
Perhaps the smartest of the smart money operate in the US Treasury market, where the most glaring divergence is occurring as yields on the long end have fallen 20bps in the past three weeks. You will recall one of the primary catalysts equity bulls have been citing as a reason this rally has legs is what is referred to as the “great rotation” out of bonds and into stocks. I tried to debunk this nonsense back on January 28 in The Great Rotation? The Market Is A Bit More Complicated Than That
If the market needs to test 143-00, next week could be a great opportunity. You can see on the chart there is enormous support in the area between 143-00 and the rising channel. The fate of the bull market will bet settled at these crossroads. Expect this area to get vibrated and the reflexivity of the MBS market to play a key role in how this gets reconciled.
Of course the stock market is playing a key role in how bond market price action is perceived. It’s not negative convexity pushing yields higher, its investors selling bonds to buy stocks. This is not a time to dumb down the interplay between stocks and bonds in as simple terms of a Great Rotation. It’s not that simple.
The 143-00 level on the US bond futures contract was a major key level for me that I cited in my year end A 2013 Bond Market Prognostication
and it in turn provided an intense bull/bear battle that I have been documenting for much of the past three months. This level in bond futures represents approximately 2.0% on the 10-year yield and 3.25% in the long bond. We closed out the week 15bps below these levels with the 10-year at 1.85% and the 30-year at 3.10%. If the great rotation was beginning to materialize these support levels should not have held. Not only did they hold, but the withstood a barrage of selling against an intense rally in risk assets.
SOMA Bid/Cover Vs. 10-Year Yield
The demand for US Treasuries can also be seen in the waning supply sold into the Fed’s QE open market bid. Coming out of the gate in January the SOMA bid/cover ratio was rising with market yields. As I implied in The Great Rotation?
I thought it could have been attributable to MBS convexity selling or other one-time seasonal events such as the expiration of TAG deposit insurance. Certainly not allocation rotation as the market pundits were proclaiming. Regardless, you can see that as the 10-year hit the 2.0% level the selling into the QE bid began to ebb and has steadily been in decline for the past two months, hitting in fact one of the lowest coverage ratios last week. If money was coming out of bonds and into stocks you would not expect investors to be withdrawing supply into one of the biggest and most predictable bids in the market. This 1.85% level in the 10-year is a critical pivot level going back to when it was first hit back during the August 2011 equity market mini crash. Regardless of direction a move from this level must be respected for what it portends about the state of the markets and economy.
Next week we will get the two most important monthly economic data reports in ISM manufacturing and non-farm payrolls. In addition we will get meetings from the newly uber-dovish Bank of Japan which is expected to launch an aggressive QE campaign, as well as the ECB, which is dealing with its own set of issues. With the 10-year sitting right on top of the key 1.85% pivot you might say this is one of the most important weeks of the year for bond market investors. If the 10-year can hold this 1.85% level amidst the stress of what appears to be improving economic data, a breakout in stocks, and exceptionally easy global central banks, you have to believe that the bond market is reflecting a dynamic that no one yet sees.
I was very skeptical on bond market performance entering this year and laid out a scenario where a monumental bull/bear battle should occur. Not only did I get the price objective test much sooner than expected, but also I got the corresponding rhetoric and interpretation of a seismic asset allocation shift that was under way only adding to bearish bond market sentiment and pressure. However now that the quarter is in the books and the smoke has cleared, the bruised and battered bond market bulls are still standing and have actually rallied back to near the highs of the year.
From where I am sitting the bond market is making a very bold statement that should not be underestimated. This past quarter the bonds were set up to reverse the rally and finally push yields higher towards more normalized levels but they just couldn’t do it. We can try to rationalize this price action with such things as the Fed buying, a European flight to quality, or a great rotation front run short squeeze. However at the end of the day the stock market is at new highs and bond yields are falling. These markets are offering very different interpretations for what is going on and they can’t both be right. The smart money seems to be fading the stock market euphoria and my money’s on them.
No positions in stocks mentioned.