The secret to analysing financial and economic data

We are very fortunate, as independent financial market traders, that the US, home to the world's oldest and largest financial stock index (the venerable Dow Jones) and futures markets, provides us with a blizzard of economic statistics far more than is issued from any other nation.

The US economy and its financial markets remains dominant in the world. The dollar has been the world's only reserve currency for several decades, since the collapse of the gold standard in the early 1970s.

That is why global markets pay very close attention to the US economy. When the US sneezes, the world still catches a cold. Asia's rise means that this may not hold true a decade from now but that's another story.

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Also, public participation in the markets is very high in the US after all, "the business of America is business" (to quote a former president). While that vision is fading, it is still true that the public's connection to the economy and the markets is strong. This ensures the markets are relatively open, government manipulation notwithstanding.

Unfortunately for us, the sheer weight of data issued is, quite frankly, overwhelming. Perhaps that is why many traders do not peek behind the curtains of the price charts to see what lies there. But they are missing a trick.

The one thing you need to watch when analysing data

In my early days, I used to pore over the 'Cattle on Feed' reports issued monthly by the US Department of Agriculture (being based in Washington, DC, I would stand in line for the poor guy to come out of his door, at precisely the appointed time, carrying an armload of reports. He'd hand them to people like me, as well as the milling throng of reporters who'd instantly dash off to their phones).

Today, of course, you do not need to do this at all. But you still have to filter information for meaning. And the most important question to answer is: what is Mr Market expecting and what does Mr Market get? When Mr Market has an overwhelming belief in a particular outcome, at some stage, this belief will be shattered and a profit opportunity beckons. To quote Joe Granville, a legendary trader: "When something appears obvious, it is obviously wrong".

Let's take a current glaring example gold. The gold price has been in a massive bull market for several years. Much of this rise has taken place due to fears that the dollar is in a long-term bear market, propelled by quantitative easing (money printing), and a general lack of faith in fiat currencies. A related concern is that, because of the huge increase in the money supply, US inflation will simply take off. Fear of 'hyperinflation' is a common theme today. Gold is said to be a classic hedge against inflation (a point I shall look at in more detail in another post).

So it seems obvious that the gold price should keep on rising as more dollars are produced. But let's see if traders are putting their money where their mouths are.

As it happens, we do have a set of data that can pinpoint exactly what the market is thinking. That data is produced by the US Commodity Futures Trading Commission (CFTC) the body that oversees and regulates the US futures markets. (The vast majority of financial trading takes place in these markets, and they heavily influence the cash markets).

Every week, the CFTC releases a breakdown of positions held by various trading categories. It is called the 'Commitments of Traders' report (COT)

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And in the related platinum market:

It is the 'managed money' category that sticks out for me. This category represents mostly exchange-traded funds (ETFs investing in the metals), and other funds that are mostly sold to the public. In gold, there are 13 times as many long contracts held (the gold bulls) as hold the short side (the gold bears). And in platinum, it is even more one-sided. The bulls out-number the bears by more than 80 to one! Remember, for each contract, there is one person on the long side and one on the short side. The number of longs must equal the number of shorts.

So here's the picture. As the market has moved up rapidly to around $1,400 an ounce, the bulls have been rushing to one side of the boat (the other side of the bet taken up mostly by the trade). And we know what happens when too many of the public crowd one side the boat eventually capsizes. This is a very clear sign of an unhealthy market and one ripe for a reversal.

But why would the market reverse in the face of such logic? There is no rational 'reason' why. All I can say is that markets swing up and down according to changes in sentiment in all time-frames (the herding impulse of traders).

Here is the gold chart showing the huge rise since about 2002:

As the market spiked to $1,250 this summer, I could see where this was going, and I would be prepared to look to short gold on a big blow-off type move. I am never happy trading with the crowd, although anyone buying gold in 2002 (they were in a minority then as gold was unloved) would be very happy today. My guess is that there are very few traders/investors who have managed to do this. Sadly, most individuals get on board any bandwagon very late in its development and this shows up very clearly in the COT reports.

The COT is not the only tool for measuring trader attitudes. There are two very important surveys that plot market sentiment the AAII survey and the market sentiment survey and I shall cover these in another post.

Of course, shorting into an exponentially rising market can be very hazardous, as markets can stretch far beyond what you believe to be sane territory! But that is where Elliott wave analysis comes in. In previous posts I have shown how I use this most important tool and it did come in useful in November, when I found a suitable spot to short. I will cover this trade in a later post.