This signals a major drop for the Dow

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.

So long as the trends remain intact, they are heroes. But when the trend changes, they can turn to zeroes.

The big players were badly caught out

Last week was a pivotal one in the markets when trends changed dramatically from up to down. This change centred on the Fed announcement on Wednesday, of course.

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

Going into the Fed report, the consensus was for more unlimited money-printing, thereby putting pressure on the US dollar. Meanwhile, the politicians in the eurozone were uttering soothing words about how the euro crisis was over. After all, sovereign debt yields of the troubled nations were falling.

This positive sentiment helped produce the 800-pip rally off the 18 May low of 1.28.

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
(Contracts of EUR 125,000) 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

 

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

In fact, it is an absolute requirement that for a major top to occur, there must be a vast majority of spec bulls in the top area – and if there has been a large increase in spec net longs near the top, then that top is likely to herald a major decline, which should be sharp and swift.

The fuel for the decline is the massed army of longs who are getting stopped out of their losing trades.

They were wrong about the S&P too

I also showed the COT data for the S&P 500 futures market in last Monday’s post, and since then, there has been a similar set-up to that in the euro.

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:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
($50 x S&P 500 index) 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

 

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

This is a very popular trading vehicle and is considered to carry more risk than the Dow or S&P as it contains more tech, biotech and unproven companies in more speculative sectors.

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
Nasdaq 100 stock index x $20 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

 

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?

It now appears my C wave down in the Dow has started:

Dow spread betting chart

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.