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How Smart Is The Smart Money?: Copper to Burst? Non-Energy Commodity Bubble?


...the markets still seem high-risk to me and I remain positioned accordingly.


A few weeks ago, I started what will now be a regular series that tracks the Commitment of Trader's Data information published each Friday by The CFTC.

As I have described previously, when you open a commodities account with a broker/dealer, you are asked to declare yourself a speculator (large or small) or a commercial 'hedging' account. Traditionally, small traders are thought to be mostly individuals, large traders are folks like hedge funds and hedgers are more of the mutual fund and pension fund community. Over the past years, many have nicknamed the hedging accounts as 'smart money.'

This by no means suggests that the speculators are 'dumb money.' But consider the following: For each trade, there is a buyer and a seller and by definition, only one of the sides will be correct in their decision. Hedgers remind much of what the specialist's community was designed to do-provide liquidity when no one else will (whether they actually do provide liquidity when the markets are at extremes is up for discussion…) when they were first formed.

So you might say that the hedgers 'take the other side of the trade,' particularly at extremes. They also have the deepest pockets and the most capital and are therefore more difficult to 'squeeze' out of their positions. It is akin to the person sitting in a 'Texas Hold Em' game with the biggest stack of chips. They can easily force the 'short stacked' player into making a weak handed bet. The guy with the short stack does win occasionally in poker, just not as often as the fellow with the largest stack. After all, he didn't attain the largest stack by accident.

Further, I would note the continued proliferation of futures trading as the hedge fund community grows quickly and uses leverage to boot to exacerbate the size of their positions. No wonder the shares of commodity exchanges like the Chicago Mercantile Exchange have taken flight by 1,000% in the past couple of years. So the bets are getting larger as volatility and volatility indices like the VIX, VXO and VXN decrease. The truly 'crowded trade' in the exchanges lately, in my book, are those funds that are elbowing each other to take advantage of the smallest amount of market inefficiency. When you apply leverage to that equation, you can understand why the volume in futures and ETF (exchange traded funds) has grown so much lately while the volume on the stock exchanges has been relatively static.

Now, to the results of my findings from this week's data. In stocks, hedgers continue to sell short the S&P 500 in near record size. Remember that the data I use is a combination of the older 'open outcry' futures as seen in 'Trading Places' and the newer, popular 'e-mini' contracts which are traded electronically. The e-mini contracts have one fifth of the value of the 'big contract' and my firm (well, actually Bloomberg does it for us!) net out the values of both the open outcry and e-mini contracts so that it is reflected in big contract terms. This is for all indexes including the SPX, Russell 2000 (small cap), NASDAQ 100, and Dow Jones Industrial Average. In addition to their short position in the S&P, the hedgers are stubbornly short the Dow and have liquidated their positions in the NASDAQ 100 and Russell 2000. All of this data, from the perspective of direction and size of their positions, indicates that the hedging accounts are selling hard to the momentum crowd. Historically, this has preceded weakness, but there is of course no guarantee that this will be the case again.

In bonds, the hedgers continue their long position in 30 year Treasury bonds and are still short the 10 year future, but much less so than a month ago. Their position in the 2 year note is fairly flat now as well. As for their overall positioning in bonds, when I add the cumulative impact of their positions in 2's, 5's, 10's and 30's, their position is basically neutral. I come to this conclusion by weighing each net bond contract by its 'duration' or inherent volatility given a change in rates.

See the charts below beginning with equities, then bonds. The last charts and discussion will be in regards to what I think is a bursting bubble in copper that I have highlighted previously. I will also highlight a potential bubble forming in 'the Goldman Sachs non-energy Commodities Index,' and look at just how important the inversion of the yield curve has been and could be to stocks and the economy in the future.

NASDAQ 100 vs. NDX Hedgers

Russell 2000 (Small Cap) vs. Hedgers

Dow Jones Industrial Average vs. Hedgers

S&P 500 vs. Hedgers Overall

2 Year Note Futures vs. Hedgers

10 Year Treasury Note Futures vs. Hedgers

30 Year Treasury Futures vs. Hedgers

Overall Yield Curve (Duration Adjusted) Hedgers' Positions vs. 10 Year Note Yield

But what about the increasingly inverted yield curve? In a new concept I have developed and will update in the future, I examine the inverted yield curve versus the S&P 500 over the last couple of market cycles. The 1995 example where the curve inverted mildly, stocks took off and then ended with the culmination of the bubble in 2000 with a brief, but difficult correction in 1998 known as the 'Asian Contagion.' We have now been inverted for a long time and are pressing pretty high levels, usually greeted with a recession or slowing economy (we are already there) in the not too distant future. The copper chart below looks like a bursting bubble to me and would be naturally parallel with a slowing global economy. As economies around the globe slow, so does the use for copper. Yes, I am aware of the new records in the Goldman Sachs Non Energy Commodity Index, but wonder if that isn't more from the bifurcation of emerging economies versus those of more developed nations, like the US. That graph is here for your perusal as well. In summation, I continue to believe that these graphical representations are in concert with sentiment indicators my firm tracks and they suggest concern about the economy and stocks in general. This is housing led my firm believes (as we have for 18 months) and think the Fed eases in 2007.

Inverted Yield Curve vs. the S&P 500 (Fed Funds Rate Minus 10 Year Note Spread)

Copper Bubble Breaking Like the NASDAQ Bubble in 2000?

Yet Another Bubble? The Goldman Sachs Non-Energy Commodity Index vs. the NDX

I hope that this information is as interesting to you as it is to me. While the charts are just pieces of the overall puzzle, they are important pieces in my opinion. I will keep you updated in the future for any significant changes. So, despite the much ballyhooed positive seasonality that we are about to experience, the markets still seem high-risk to me and I remain positioned accordingly.

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