There was some excitement last week when SentimenTrader wrote about the massive aggregate short by large speculators and CTA trend followers in equity futures. Conventional contrarian analysis would be bearish, but this is a lesson for traders and investors to look beneath the surface before jumping to conclusions.
Here are some mitigating conditions to consider. Analysis from Callum Thomas revealed that, when normalized for open interest, the short position is not as extreme. Further analysis shows that large speculators were mostly correct in their positioning just before and during the Great Financial Crisis. This is a lesson not to be contrarian just for its own sake.
In addition, Goldman Sachs’ positioning studies show that investors, which include institutions, individuals, and foreign investors, are net long equities. Readings are falling from a crowded long and not extreme. These sentiment conditions are consistent with a market that is pulling back.
If you are relying on Commitment of Traders (CoT) futures data to be contrarian, then what would you make of the massive USD short position (via Macro Charts)?
Large speculators are in a crowded USD short, and the USD Index has just staged an upside breakout from a narrow range and sparking a risk-off episode. The AUDJPY cross, which is a sensitive risk appetite foreign exchange indicator, is confirming the risk-off tone.
Taking a contrarian position based strictly on CoT data can lead you astray. How do you resolve the inherently contradictory positions of a massive equity short, which leads to risk-on positioning, and an equally massive USD short, which leads to a risk-off conclusion?
I interpret CoT data as trade setups, and not actionable trade signals. I prefer to look for crowded trades, combined with a trading catalyst. As an example, the crowded USD short and upside breakout leads me to adopt a risk-off tone. On the other hand, I am watching if the bulls can rally the NASDAQ 100 above its 50 day moving average. Most of the large speculator short positions are in the NDX, and a decisive upside breakout will lead to a short squeeze. Based on Monday’s close, the NDX has broken up through its 50 dma, though TRINQ shows no signs of panic buying. Trend following CTAs tend not to react instantly to breaches in key levels in order to minimize whipsaw. We will have to watch if the bulls can hold these levels over the next few days.
However, the market is overbought in the short-term. I will be closely watching the NDX, as well as the behavior of the currency markets in the next couple of days.
The jury is still out on question of whether today’s market action is the start of a pain trade for the bears, or a bull trap. Stay tuned.
Disclosure: Long SPXU