Even the Pros Are on the Defensive

08/05/2011 6:00 am EST

Focus: STOCKS

Andy Waldock

Founder, Commodity & Derivative Advisors

Recent shifts in commercial trader sentiment show that even the smart money is seeking shelter in this environment, as evidenced by recent action in stock index futures, bonds, currencies, and gold.

Commercial traders are building the case for their negative outlook on the stock market. Their actions in several markets can be seen as being increasingly defensive over the last several weeks. Their behavior is also beginning to be confirmed by several technical indicators, some of which are at levels that haven’t been seen in nearly 15 years.

Last week, we used the employment situation, profit margins, and earnings to suggest that it would be an historic event to start a new bull market leg upwards from these levels, and therefore, the short-term pop on the debt-ceiling rally could be sold in the stock index futures market to generate a short-term profit.

Deeper analysis reveals that selling stock index futures at these levels may be an appropriate hedge for the longer term.

We all know that trading volume declines in the summer months, and the “dog days of August.” Lower volumes and fewer market participants lead to higher volatility.

Monday morning’s selloff in the S&P 500 was dramatic enough to make me sit up and take notice. The market opened at 9:30 am ET more than 1% higher thanks to the resolution of the debt-ceiling deal.

The market then promptly sold off nearly 3% in a couple of hours. The speed of its fall is what is noteworthy. A closer look shows that the number of market participants, as measured by open interest, is the lowest it has been since 1997. Open interest peaked in December 2008 at more than 755,000 contracts. It is currently under 300,000.

Declining open interest becomes increasingly negative the further the market moves. Friday’s close marked the first week the S&P has closed under its 40-week moving average since September of last year. A simple timing model using the 40-week average and some interest rate calculations will provide far superior risk-adjusted returns simply by staying out of a weak market that is trading below this level.

Moving to commercial trader analysis, we can see that they have increasingly sold stock index futures since mid-June, in line with the debt-ceiling concerns. Their defensive trading behavior can also be seen in their purchases of US Treasuries. They have been solid buyers over the last several weeks, with a strong emphasis on short-duration maturities like Eurodollars and the two- and ten-year Treasury notes.

The last part of the intermarket puzzle is the strong move to US cash reserves via the US dollar index. Commercial trader buying has increased by a startling 70%, or more than 17,000 contracts, in the last week.

Given the troubles coming to a budget agreement, I looked into why money was coming into the dollar. The simple answer is that it’s a value play relative to the euro currency and the gold market.

The recent European Central Bank (ECB) bailout of Greece is seen as a band-aid on a chain saw wound. Two ECB questions remain: When will Greece default, and will Italy and Spain be next?

The markets continue to question whether they will be able to continue paying their debts, and this can be seen in the record-high interest rates they are being forced to pay in the open market.

Finally, commercial traders see the typical safe haven—gold—as being overvalued. Small traders and funds are holding a near-record long position in the gold market. The concern is that when the stock market fails and cash needs to be raised, it can only come from positions that are profitable. This would lead to profit taking in the gold market and drive it lower.

Since small traders and funds are typically quicker to react to major market moves, the concern is that when the gold market falls, it could fall quickly and deeply. This would wash out many of the small traders and put gold back into play for the commercial hands waiting to buy the market again.

By Andy Waldock of Commodity & Derivative Advisors

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