Tuesday, 12 June 2007

"Big Money in the Main Movements"

Last week's market craziness continues as we speak. The uptrends in the major equity indexes since March appear to have broken (even if not decisively just yet).

Wall St. and regular folks alike are all wondering where it will stop. Will the recent lows hold? Are rising bond yields going to break the market's back? Is this 1987 all over again?

One answer may lie in the Commitments of Traders reports. Last Friday’s report - based on data as of last Tuesday, June 5 - showed the “smart money” commercial hedgers still heavily net long the S&P 500 index. Meanwhile, the "dumb money" large speculators - so called because they tend to get it wrong at market turns - are still heavily net short the NASDAQ, a bullish sign.

For other indexes, the picture is essentially neutral. Overall, the latest report hasn't overturned any of the bullish signals that my system generated before for equities. Same thing for the bearish signals in the metals and energy. That would change only if traders register new historic extreme net positions in the other direction. So for me and my positions, that means the existing signals are still good.

All this market turbulence does raise another question I also posed in a report I just did for Kitco.com, the bullion website: Should we worry about weekly fluctuations in the COTs data? I don’t believe so. Anyone trying to find correlations between weekly changes in the data and market prices will quickly come to a surprising conclusion: There is virtually no correlation.

This might be puzzling to readers of the financial media, which widely reports on the COTs reports’ weekly changes in the number of contracts in various markets.

But such short-term changes have little value for trading purposes, as the lack of correlations shows. Last week, for example, the COTs data was fairly upbeat for precious metals, as the commercial traders slightly reduced their net short positions in gold and silver. We might have expected prices to rise. Instead, there was a rout.

So are the COTs reports worthless? Analysts have been befuddled about the data for years. It has to mean something, they thought. A breakthrough came when some clever analysts suggested it’s best to follow the commercials when they reach historic extremes in their net percentage-of-open-interest positions. I think that’s the right approach.

My own twist on it is that I found it was best to fade - or trade opposite to - the large speculators and small traders in some markets. Also, I think it’s important to backtest and validate the specific historic extremes that have led to the most consistently profitable, least-volatile trading signals in each market.

That’s why I don’t get too excited any more about short-term changes in the COTs data. Edwin Lefèvre said something along similar lines in Reminiscences of a Stock Operator. (Yes, here's another quote from this great read.) “The big money was not in the individual fluctuations but in the main movements… I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight!”

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