Caution Lights in the S&P 500

We see caution lights ahead in the S&P 500 futures. The market has rallied more than 12% since the November 9th low, and we see a significant change in the makeup of the market’s consensus as we make new highs towards inauguration day.

We take most of our cues from the Commitments of Traders report. This weekly report published by the Commodities Futures Trading Commission (CFTC) aggregates the actions of the market’s major participants the large speculators, the small speculators and, the commercial traders. We track their actions on both a net and total position basis. Our trading methodology involves identifying unsustainable imbalances between the commercial and speculative traders when a given market is trading at overbought or, oversold levels as identified by the short-term momentum indicator on the included chart. Based on our research, we’ve determined that these market imbalances typically resolve themselves in favor of the commercial traders’ momentum. Partly because the commercial trader total position is more than 4.5 times the size of the speculators’. We make our profits by capitalizing on a given market’s reversal as it moves back in line with the commercial traders’ momentum and the overloaded large speculator position begins to reset itself.

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The story of the current cycle runs as follows. Both the commercial and speculative traders had pared their positions before the election. However, commercial traders were huge buyers immediately following the election, purchasing more than 145k contracts in just three weeks. The speculators, on the other hand, sold more than 135k over the same period. Predictably, the speculative short position didn’t pay off, and they were forced to buy back their short positions at all-time highs. These new all-time highs are where the commercial traders are now dumping their long positions as the speculators pull a full reversal from post-election short selling to pre inauguration new high, breakout buying. This leaves the large speculators as the only long positions in a market at all-time highs, holding the proverbial “hot potato.”

The current market imbalance places newly long speculative money at the greatest risk. It has been our experience that these cycles typically take 5-7 weeks to materialize. We are currently approaching week 6. Caution should be taken to protect long positions and an extension of the rally this week should be viewed as a short selling or, stock portfolio hedging opportunity.