Bearish Signs Stock Traders Are Missing

02/17/2012 12:26 pm EST

Focus: STOCKS

Andy Waldock

Founder, Commodity & Derivative Advisors

Record long positioning and the end of a seasonal strong period are only a couple factors that could bring on a stock reversal, and it seems only the smart money is positioned for that possibility.

Commercial traders tend to be negative feedback traders. Their large account sizes and ability to deliver the physical product allows them to absorb market swings that an individual trader would not be willing to sit through.

The Commitment of Traders (COT) report identifies large speculators as trend-following commodity trading advisors (CTAs) and commodity index traders. CTAs are the individual money managers within the futures industry and commodity index traders are like mutual fund managers.

These three types of traders account for most of the volume along with small speculators— individuals who trade their own accounts—filling out the balance. The purpose of these definitions is to illustrate the battle lines that the markets draw at major turning points.

Speculative traders, whether large or small, tend to increase the size of their positions as the markets move their way and their account values increase, thus giving them more cash to work with. Commodity index traders are forced to maintain certain allocations, which also forces them to buy more as the markets climb and sell off those very same positions as the markets decline. There is currently an historic battle shaping up in the stock index futures as these market players duke it out.

See related: Find Useful Signals in the COT Report

This past week, non-commercial traders (the large speculators) set a new all-time net-long record in the Nasdaq futures. Interestingly, neither the Dow nor the S&P 500 are anywhere near their speculative highs. Clearly, tech has been leading the way.

The Nasdaq position makes sense in the behavioral pattern we’ve laid out. It has been the strongest of the three major stock indices and rightfully has attracted the greatest amount of capital. Unfortunately, the size of the position being bought above the July highs around 2450 leads to a weak-handed, top-heavy market.

There are several clues pointing to the end of this rally, starting with the most obvious: the golden cross. This happens when the 50-day moving average crosses above the 200-day moving average.

See related: Golden Cross: Reliable in Any Market

This happened in the S&P 500 for the 26th time since 1962 two weeks ago and also applies to the Nasdaq discussion. CNBC ran this story incessantly. The statistics behind it show that of the 26 crosses, the market is higher six months later 81% of the time. (Read more about these golden crosses here.)

That’s a great stat, and I’d like to believe that six months from now the market will be higher. However, I think the publicity was just enough to suck in the blind-faith investors, as evidenced by the large spike in small speculator long positions.

Deeper investigation shows that commercial traders are also raising their stakes in markets that move opposite the stock market; they have been moving money into the US dollar. The dollar tends to rally as investors pull money out of the stock market and move to the safety of cash. Over the last three weeks, they’ve nearly doubled their position, switching from net short to now long the dollar.

Commercial traders have also continued to pour money into the ten-year Treasury note futures. In fact, they have increased their position in this market every week since December 12. This is also a defensive play against the stock market.

Finally, I’ll turn to the end of the “January Effect.” This is the period from late December through the middle of January that is the strongest period for the Nasdaq. Historically, this was due to year-end bonuses being paid out and finding their way into the market via retirement or direct investing by the bonus recipients. Unfortunately, the fundamentals have changed and this is no longer a direct cause-and-effect relationship.

The end of the January Effect is rapidly approaching. Moore Research, a seasonal analytics firm, confirms the January Effect but also notes that the seasonal trough is typically made between February and March.

I expect the market’s low volatility to provide us with a low-risk opportunity to enter some short positions in line with commercial traders and catch the fall as the latecomers are forced to bail. The Nasdaq should come back and test the 200-day moving average around 2300, more than 10% below our current levels.

By Andy Waldock of Commodity & Derivative Advisors

Related Articles on STOCKS