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Following the Money

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I've mentioned the activity of large commercial traders in various pieces over the past year, whether it be in relation to gold, bond or stock futures. Currently, there is an interesting shift that has taken place in stock futures that should be mentioned.

Recall that commercial traders are large funds that hold at least 1,000 contracts of the full S&P 500 futures contract. By definition, they use the futures markets for hedging purposes, and not for outright speculation (whether this is actually the case or not is questionable). For the latest reporting period, which covers the week through Tuesday, January 20th, commercial traders were shown as holding more contracts long than short, which is a shift from their recent position. The last time commercials shifted from net short to net long was in March of last year, which is why this data is getting some attention this time around.

For many months now, I have discounted the impact of this Commitments of Traders data. Over the past year or so, expirations have been having an outsized impact on the position changes, and the swift rise of the e-mini contract as a viable alternative has rendered changes in the full contract more difficult to read. Very often, commercials will become longer in the full contract but shorter in the e-mini. In fact, over the past 12 months, the correlation between changes in the full contract and changes in the e-mini has been -0.89 (out of a scale of -1 to +1). This is a very high negative correlation, and I think it's highly doubtful this is just coincidence. There is little doubt that commercials trading the full contract are also taking positions in the e-mini, so looking at one without the other can be misleading.

However, for now, let's just look at the full contract. Over the time this information has been available, going back to 1986, it has paid handsomely to be on the same side as the commercials. Meaning, when commercial traders were net short, the market went down more than up; when commercials were net long, the market went up more than down. For example, 16 weeks after any week in which commercial traders were net long, the S&P 500 was an average of 5.3% higher, and it was up 81% of the time. Conversely, 16 weeks after they were net short, the S&P showed an average return of minus 1.5%, and was up only 44% of the time.

Looked at another way, if one went long the S&P 500 cash index when commercial traders switched from net short to net long, then went to cash when commercials switched back to net short, $10,000 would have grown into $107,000 from 1986 - present. If one had entered a short position instead of going to cash when commercials switched to net short, then that $10,000 would have jumped to $189,000. This is compared to a buy-and-hold ending balance of $55,000. Also, the maximum drawdown one would have suffered during this time would have been much less by following the commercials than by simply buying and holding. Please note that this is not meant to be a viable trading system, and I highly discourage anyone from buying and selling based on this data alone. As I said above, for various reasons commercial behavior in this contract may not be as reliable as it used to be, not to mention the fact that there is a four-day delay in the release of the information to the public. So the positions have changed - possibly greatly - by the time you even get the data.

Still, I think it's helpful to know that in the past, commercial traders switching to a net long position from net short has been a telling sign that higher market prices were in store. We saw that in spades just this past March, and I am watching the current situation carefully. While there are many, many extreme negatives from a sentiment standpoint, I would be remiss not to also mention the positives.

No positions in stocks mentioned.

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