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Smart Money: Buy Dip in Stocks, Sell Rally in Treasuries


While it may pay to be long term cautious, it's also important to understand that there will be interim opportunities from the long side in stocks.

My firm has been tracking the commercial hedging accounts or so called "smart money hedgers" for quite some time. I have noted many times in the past that they were leaning hard against the relentless run in stocks that started last summer and ended with a thud in the last week of February.

Smart money usually operates under the mantra of "buy low sell high" or "buy from the fearful and sell to the greedy." As a contrarian, value based investment manager, I operate under the same tenets. Of note, during the recent sell-off, hedging accounts covered approximately half of their short position (please note that my firm calculates the hedgers' positions in "big contract" or "open outcry" futures contracts (like the folks you see yelling and screaming in the Chicago futures pits). I do this because in recent years not only has futures volume picked up dramatically but it has picked up even more so in the "e-mini" of electronic contracts. Note that e-mini contracts represent approximately one-fifth the value of the big contracts.

Importantly, not only is the size of their position important but the direction of their bets as well. I will note that hedge funds reportedly had record long positions around the top of the move in the S&P as they are notoriously a "trend following" crowd. Since the sell-off began, there have been many stories of large macro hedge funds having been hurt by the selloff. I have no doubt that the contrarian hedgers are more than glad to take their exposure from them as prices cascade lower.

There are no shortage of scapegoats to blame for the sell off; the unwinding of the "yen carry trade," the implosion of sub-prime lenders, and the price of oil soaring to $62 per barrel. Personally, I think it could be a combination of factors, but most importantly because of the complacency that had gripped the market. In addition to the hedging accounts covering many shorts in S&P futures, they also went net long the Nasdaq 100, record long small cap stocks and began covering their shorts in the Dow Jones Industrial Average. These folks aren't called "smart money" for nothing I guess. At any rate, please find the charts of the four indices below along with the hedgers' positions.

Hedgers vs. S&P 500

NASDAQ 100 vs. Hedging Accounts

Dow Jones Industrial Average vs. Hedgers

Russell 2000 vs. Hedgers

But what about the bond market?

As the hedgers were heading from short to long, they re-upped their bets against the bond market, notably in the 10 year note. Please see the chart here and note the increased short position.

10 Year Futures vs. Hedgers

Why are they selling bonds? I have noted many times that seasonality in bonds is negative until the end of May. Adding to the fact that the curve is as inverted as it has been all year and the fact that 10 year yields look unattractive relative to the front end of the curve; they are sellers, as is my firm. I do not see much value in the 5 to 10 year part of the Treasury curve around 4.45-4.55% either. See the chart below courtesy of Ned Davis Research that highlights Treasury seasonality on a month by month basis.

In sum, while I am long term cautious, I also understand that there will be interim opportunities from the long side in stocks. I am looking for a March 1st top and a sell off into April. My clue will come from some seasonal patterns as well as sentiment indicators should they turn towards "extreme pessimism." Some of the polls that my firm tracks are already heading in that direction. I still expect a major top this fall followed by a steep drop into 2008 as the sub-prime contagion eventually spreads. As I have thought for the better part of two years, housing is a mess and a credit crunch could develop. Hence, I am avoiding credit risk entirely as I am not being compensated for credit risk.

I also have talked a little bit about the concept of "zero hour"-the time when monetary stimulus no longer affects the real economy. While not there yet, we are on the road towards it. Some fiscal restraint is necessary, but it is not likely the year before a presidential election. So, what stimulus might be provided by the Bush administration to pump up consumer confidence and stocks to give everyone that great feeling? Here is a crazy concept that I know is controversial and a long shot but worth considering with a Democratic Congress and House.

Let me leave you with this thought. What might happen if we pulled out of Iraq? The world markets would likely rally, bonds would sell off and consumer confidence might rise. I know it is a long shot, but it's worth thinking about nonetheless. Politicians have a way of pulling out all stops to win if history is any guide.
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