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This signals a major drop for the Dow
Even the biggest players can be caught out by big moves in the markets, says John C Burford. But by sticking to your trading methods and watching for sentiment, you can avoid making the same mistakes.
As you know, I rely on the weekly commitments of traders (COT) data from the US Commodity Futures Trading Commission to help me understand how the internal strength or weakness of markets is changing over time. Such information, although reported several days in arrears, adds significantly to the evidence I like to assemble to suggest a trade.
And last Friday's data certainly illustrates a key principle with futures markets that the large non-commercial sector (primarily hedge funds) are mostly trend-followers.
When hedge funds believe they have spotted a trend, they use the momentum to jump on board and in the process, help drive prices their way, as they trade in such large size.
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As it happens, the COT data refers to the situation every Tuesday and that was just prior to the topping process on Wednesday. How very timely!
Thus, we are seeing how the markets were positioned just before the Fed spoke. Remember, markets were generally rising going into the report as the big players guessed the Fed would make no changes to its quantitative easing (QE) agenda, which had been very supportive to markets.
But how wrong they were! The Fed gave the strongest possible hint that they were ready and willing to wind down QE, depending on circumstances.
So let's see how badly the hedge funds were prepared for this change.
The euro set-up
This positive sentiment helped produce the 800-pip rally off the 18 May low of 1.28.
Swipe to scroll horizontally
(Contracts of EUR 125,000)
Row 0 - Cell 1
Row 0 - Cell 2
Row 0 - Cell 3
Open interest: 213,331
Commitments
91,304
71,274
4,883
64,586
80,432
160,773
156,589
52,558
56,742
Changes from 06/11/13 (Change in open interest: -47,087)
22,348
-5,215
-9,977
-64,115
-26,361
-51,744
-41,553
4,657
-5,534
Percent of open in terest for each category of traders
42.8
33.4
2.3
30.3
37.7
75.4
73.4
24.6
26.6
Number of traders in each category (Total traders: 165)
48
50
17
39
42
96
100
Row 8 - Cell 7
Row 8 - Cell 8
For the week ending last Tuesday then, the hedge funds piled into the rally by increasing their longs by a massive 20% - and reduced their shorts by 7% - for a net swing to the bullish side of almost 30% on the week.
And the small traders weren't left behind with a big net swing to the bull side.
I guess they were not aware of what was going on in the gold pit. The sinking gold price should be negative for currencies against the dollar. And that divergence was another clue that the euro was primed for a fall.
And since Wednesday, the EUR/USD has lost 300 pips. I call that very poor timing by the hedgies! It only proves that the best brains in the business can get it very wrong and also proves that, armed with the COT data, a small trader can beat the big boys, provided you use a solid trading method.
How tops are formed
The fuel for the decline is the massed army of longs who are getting stopped out of their losing trades.
Prior to the Fed report, the consensus was for the Fed to continue to support equities in the status quo. They were hoping the report would vindicate their bullish position. After all, many have been calling this the start of a 'great bull market', as the 'great rotation' out of bonds would occur.
So let's see how the players were aligned last Tuesday:
Swipe to scroll horizontally
($50 x S&P 500 index)
Row 0 - Cell 1
Row 0 - Cell 2
Row 0 - Cell 3
Open interest: 3,746,507
Commitments
481,489
364,545
165,241
2,678,557
2,883,626
3,325,287
3,413,412
421,220
333,095
Changes from 06/11/13 (Change in open interest: 349,100)
24,918
22,796
18,793
218,141
303,750
261,852
345,339
87,248
3,761
Percent of open in terest for each category of traders
12.9
9.7
4.4
71.5
77.0
88.8
91.1
11.2
8.9
Number of traders in each category (Total traders: 545)
117
97
76
232
241
385
380
Row 8 - Cell 7
Row 8 - Cell 8
The hedgies increased both their long and short bets, but look at what the small specs were up to. They added mightily to their long positions by a whopping 26%.
Thus, they went into the report with a 26% increase in longs for the week.
Again, this is a likely prelude to a major disappointment, especially since it was the small specs who were betting big. These are the weakest hands, remember.
Markets exist to disappoint the majority, especially if they are small specs.
Eight-to-one longs on the Nasdaq
Swipe to scroll horizontally
Nasdaq 100 stock index x $20
Row 0 - Cell 1
Row 0 - Cell 2
Row 0 - Cell 3
Open interest: 457,197
Commitments
117,095
15,008
11,250
293,539
406,753
421,884
433,011
35,313
24,186
Changes from 06/11/13 (Change in open interest: 67,952)
10,287
4,765
7,321
45,950
59,330
63,558
71,416
4,394
-3,464
Percent of open in terest for each category of traders
25.6
3.3
2.5
64.2
89.0
92.3
94.7
7.7
5.3
Number of traders in each category (Total traders: 211)
72
17
20
81
72
161
102
Row 8 - Cell 7
Row 8 - Cell 8
Just admire the ratio of hedge fund longs to shorts it is almost eight-to-one. That is a lop-sided ship! And both spec groups increased their long bets just prior to the Fed report.
Again, this is a set-up ripe for a major disappointment.
These are just three major markets that are giving a strong signal that if last week did see a genuine major turn, the decline should be fast and furious, since so many spec longs jumped on board recently, newly-converted to the bullish cause.
Has the Dow turned?
If these labels are correct, this C wave down which is a third wave and therefore long and strong will take no prisoners.
Many will try the old trick of buying the dips, which has worked so well up to now. But C waves can be relentless just observe the two C waves on the way up from the 2009 low in the large b wave. The dips along these two C waves were relatively minor.
But this C wave is of greater magnitude than those two, and should pack a much greater punch.
The second half of 2013 is shaping up to be very exciting.
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John is is a British-born lapsed PhD physicist, who previously worked for Nasa on the Mars exploration team. He is a former commodity trading advisor with the US Commodities Futures Trading Commission, and worked in a boutique futures house in California in the 1980s.
He was a partner in one of the first futures newsletter advisory services, based in Washington DC, specialising in pork bellies and currencies. John is primarily a chart-reading trader, having cut his trading teeth in the days before PCs.
As well as his work in the financial world, he has launched, run and sold several 'real' businesses producing 'real' products.
