Weekly Economic Update 09-14-2018

The Long and Short of Market Speculators

For the past two years I have written and shared charts about how speculators are positioned in the markets. Who are these speculators? Who is betting against them? How does the more speculative side of the stock market really work?

Speculating against the stock market is often a misunderstood concept. Rather than taking a position by purchasing a security, speculators actually speculate against the direction they believe a security is going to move—either up or down.  Speculating against the market is the purest form of betting in the market.

This form of betting is done in the futures market where market participants can buy a leveraged position against the stock, bond, commodities, and currency markets. Unlike a stock or bond which is a single security, a futures contract is a leveraged position against a security.

For example, an S&P 500 futures contract may be a ten-times leveraged contract against the movement of the S&P 500. Depending on the direction the S&P 500 moves, and how the speculator is positioned, it could generate a ten-fold gain or loss. Due to the speculative nature of the futures market and the large amount of money it takes to buy a futures contract, most retail investors will never have any exposure to this type of contract.

There are two main participants in the futures market: Commercial Hedgers (also known as the Smart Money) and Managed-Money Traders (the true Speculators, or Dumb Money).

The Managed-Money Traders are mostly Hedge Fund managers who have hundreds of billions of dollars at their disposal. Typically, they are trend followers and have no intention of holding their contracts to maturity. At the maturity of a futures contract, the contract owner takes delivery of the underlying security.

The Managed-Money Traders are trying to make a return on the movement of the market, but they often find themselves on the wrong side of the trade. This is why they are referred to as the Dumb Money. The Dumb Money may be right for periods of time but it is the Commercial Hedgers who are usually on the right side of a trade.

The Commercial Hedgers are those who use the futures market to hedge their position. They are producers, such as farmers and miners, manufacturers, managers of institutional money and large pension funds, banks, and other large non-speculative hedgers. The reason Commercial Hedgers are referred to as the Smart Money is because they obtain a large amount of information about their crop, ore, product, service, or sector, when compared to the speculators. The Smart Money is most often on the right side of every trade.

Not all traders believe the Commercial Hedgers are the Smart Money. Some traders believe following the Speculators is the best way to make money since they are solely interested in making a profit on their positions. The challenge with following the Speculators is they can move very quickly on a position, leaving retail investors scrambling as sentiment changes.

However, more experienced traders believe the Commercial Hedgers are the Smart Money and attempt to position their investments to move with the Smart Money. More often than not, the Commercial Hedgers are on the right side of the trade. It is easier to follow the Smart Money because they tend to move slower than the Speculators, which allows smaller investors a better opportunity to profit as sentiment shifts in favor of the Smart Money.

Following the last presidential election, a popular trade has been shorting U.S. Treasury bonds based on the belief that President Trump’s policies are inflationary. As I have shown in multiple prior updates, inflation is an expansion in the money supply which is multiplied through the banking system. Due to the shrinking number of commercial banks in the United States, which is the foundation for the money multiplier, it is currently not possible for us to experience true inflation. However, these facts have not stopped Speculators from shorting Treasury bonds.

For any “bet” there must be a counterparty. One cannot short Treasuries if nobody is willing to take a long position. Some suggest Speculators are always opposite Commercial Hedgers, but that isn’t always true. Speculators could be battling other Speculators or Commercial Hedgers. It varies. There are times when the Commercial Hedgers and the Speculators are diametrically opposed, which is happening with Treasury futures today.

The large commercial banks are the Smart Money who are buying Treasuries. Banks understand that the Fed’s Quantitative Easing caused long-term interest rates to rise, and therefore, under Quantitative Tightening, long-term interest-rates should fall. The banks want to buy bonds just as much as the Speculators want to short them. For the past two years, the banks have been taking the opposite end of the trade.

When looking at the Commitment of Traders (CoT) positioning reports, which are published every Friday after market close, the public can see how both parties were positioned as of that Tuesday. Currently, there is the largest speculative short position in U.S. Treasuries while there is simultaneously the largest long position held by the Smart Money.

In the futures market, participants on both sides can take delivery of their contracts or exit their contracts prior to delivery. Speculators never intend to take delivery of their contracts; they are just using futures contracts as a leveraged play in the stock market. Commercial Hedgers intend to take delivery of their contracts, which means the banks will take delivery of the underlying Treasury bonds at some point in the future.

Since Commercial Hedgers intend to take delivery of the underlying contract, which could be shares of the S&P 500, a bushel of hay, or a barrel of oil to name a few, it makes them the Smart Money. The Smart Money didn’t become smart my taking delivery of money-losing contracts.

But the Speculators have a different agenda – they want to maximize their profit on a swing in the price of a security. Speculators are trying to get as many investors to take a similar position to theirs, in order to maximize their profit. Speculators will use any means possible, including the financial media, to convince investors both large and small to get on the bandwagon. Usually, a trend will start when Speculators take a large position in a security which is followed by an onslaught of media attention as to why this sudden move in a security is justified. Once the public has fully bought in, the Speculators will begin moving in the opposite direction.

Investors can follow the Commitment of Traders data, but most don’t know how to read or even how to find it. Due to the lag in publishing the CoT data, most investors who solely focus on this report will find themselves continuously chasing the Speculators. To avoid constantly chasing the Speculators, investors can use price charts to identify when the trend is about to change.

The chart for 10-year Treasury yields shows yields have been oscillating between 2.8% and 3.1% for the past nine months. Despite a persistent record amount of short-selling by the Speculators, yields have not risen past 3.1%. This chart action shows us there aren’t many investors left who want to sell their Treasury bonds and there is consistent buying by the Smart Money.

The chart further shows the Speculators have been pressing their bets that Treasury yields are going higher when yields fall to near 2.8%, which has become a line-in-the-sand between the Speculators and Smart Money. While yields have briefly dipped below 2.8% in the past nine months, each time they have, the Speculators aggressively stepped in to defend their position.

Most likely the next time yields fall below 2.8%, the Speculators will quickly begin to exit their short position as it will become obvious yields aren’t headed any higher. As Speculators exit their short position, they will become buyers of Treasuries, which will cause yields to fall and Treasury bond prices to rise.

Yields will first fall to approximately 2.6%, which is the previous yield where the Speculators were pressing yields higher in late January 2018. As this move down in yields gains momentum, more Speculators will exit their short positions as they risk losing money. The more Speculators that turn into buyers, the faster yields will fall. The next major line-in-the-sand is around 2.3% on 10-year Treasuries.

Should there be enough momentum behind the buyers at 2.3%, it is likely all the Speculators who have been short between November 2016 and December 2017, where yields oscillated around 2.3%, will also become buyers. Should that happen, which I believe it will, yields will be on a fast track to their lowest level in history.

Should this drop in Treasury yields happen, which I believe it will, it will happen as quickly as it has in the past. A rapid fall in yields will cause many other investors who have bought into the belief yields are only going higher, to be in a losing position. In this case, it makes sense to invest with the Smart Money who believes Treasury yields will ultimately fall.

Understanding how both the Commercial Hedgers and Managed-Money Traders are positioned can help any investor with managing investments and determining where to invest going forward. Sometimes, as is the case with U.S. Treasuries, knowing the Smart Money believes yields are likely to fall, allows an investor to be more patient with their position, allowing the battle between the Smart Money and Dumb Money to play out.

Charts confirm that following the Smart Money is the best way to invest, whenever possible. Prices of a security tend to rapidly rise as the Speculators exit their short positions. It helps to wait until Speculators have exhausted all other sellers before taking a position.

When an investors find themselves on the wrong side of the Speculators, the best move is to be patient and wait, especially when the Smart Money is taking the opposite end of the trade.

In today’s market, Speculators are long stocks, long oil, short Treasuries, short agricultural commodities and short gold, to name a few positions. The Smart Money is on the opposite of all those trades, which tells us at some point in the future that stocks should fall, oil should fall, Treasuries should rise, agricultural commodities should rise, and gold should rise.

Understanding how the big players are positioned, along with a little patience, can lead to being on the right side of the market. No speculation needed!

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Daily Market Briefs

  1. Thoughts from the Weekend

Corporations have pledged to repurchase $1 trillion of their own stock back this year, which is creating an opportunity for corporate executives to sell their shares to an indiscriminate buyer. In August, corporate executives cashed out over $10 billion of their own stock, the largest amount since November 2016.

Year-to-date, corporations have purchased $850 billion of stock, leaving $150 billion for the last four months. The Federal Reserve’s monetary tightening has largely offset this, as the stock market has barely set new highs despite this huge amount of money flowing into stocks.

The Fed is expected to unwind $240 billion from its balance sheet by year-end, not factoring any increases in the Federal Funds rate. With the Fed set to increase their tightening to $50 billion per month starting next month, it is unlikely corporate share buybacks will be able to continue boosting the market.

It will be interesting to see if the stock market can continue rising over the next couple months or it will be countered by the Fed’s monetary tightening.

For the stock market Bulls, corporate share buybacks are expected to drop 30% next year to $700 billion as the Fed is minimally expected to unwind $600 billion next year.

  1. What happened to the stock market on Monday?

U.S. stocks opened higher on news that House Republicans were proposing a second round of tax cuts to make lower individual rates permanent, to eliminate the maximum age for some retirement account contributions and to allow new businesses to write-off more of their startup costs. Only tech stocks and small-caps could hold their early gains as the S&P 500 and DJIA faded into market close.

Treasury yields opened higher on the same news but closed slightly lower on the day. Physical gold was flat, whereas the large gold miners failed to hold a weak technical level, which suggests prices on the large mining stocks are headed lower.

Agricultural commodities jumped this morning with little sign of sellers in the market. Sellers may be exhausted, or the hurricane headed towards the East coast could be the reason for higher agricultural commodity prices.

The big move today was in volatility as the VIX was once again crushed to the downside, but stocks didn’t react. When stocks don’t react to a big drop in volatility, it’s another sign liquidity is slowing draining from the markets.

  1. What happened to the stock market on Tuesday?

Yesterday’s attempt to push stocks higher failed, but today’s hammering of volatility appears to be working as stocks are effortlessly moving higher. The financial media reported this morning that long-term Treasury yields were headed higher due to today’s upcoming three-year Treasury auction. I don’t think so…

There is a record short position on long-term bonds, which indicates speculators believe long-term bond yields are headed higher. The argument for this has to do with the record amount of debt being issued by the U.S. government to fund its deficits. Long-term bond yields are correlated to large budget deficits, but not to the upside.

Since the 1980’s, which Reagan began deficit spending, yields have fallen. The notion that long-term bond yields need to rise to offset large government deficits is false. The problem for the speculators, who are holding the largest short position in history, is rising short-term bond yields.

The Fed is raising the Federal Funds rate, which affects short-term bond yields. The Fed is also unwinding its balance sheet, which causes long-term bond yields to fall. The risk to the speculators is when the yield curve inverts.

An inverted yield curve is when short-term yields are higher than long-term yields, which indicates something is wrong with the financial system. Banks borrow against short-term yields and lend against long-term yields, so as the yield curve approaches inversion, banks cut bank on lending.

Less lending means less money entering the economy. As less new money is created, the economy risks falling into a recession as the money supply decelerates towards zero. To keep the game going, speculators need to make sure the yield curve doesn’t invert.

The only way to do that is either to get the Fed to stop hiking, which isn’t going to happen, or continue to push long-term yields higher until the economy breaks under the weight of tighter financial conditions.

Interest rates rise due to demand or due to a perceived increase in the money supply, which leads to increased demand. Let’s say a bank has $5 million they want to lend out to customers who want to buy a new car. After running a marketing campaign to find new borrows, the bank receives applications for $10 million in potential new car loans. Due to the unexpected demand, the bank raises interest rates until they have $5 million worth of new loans from their customers who are willing to pay a higher interest rate for their new car. That’s how interest rates can go up.

On the macro front, wholesale inventories are rising at a rate of +0.6% MoM, which is a sign of increased confidence by wholesalers who believe demand is increasing. At the same time, wholesales sales were flat. Demand is starting to slow.

Stocks surged today but the more interesting news is in the bond market. Ten-year Treasury yields backed up to 2.97% which has been an area of strong resistance going back to June and August. A resistance level is where previous buyers or sellers have bought or sold. Markets frequently retest resistance levels to find out how convicted investors are at certain points.

Bond Bears are hoping the recent buyers from June and August are going to turn into sellers, which would cause yields to further rise. Bond Bulls are hoping the buyers back in June and August hold their position.

To keep score, the Bulls are in the 2.96x-3.1x% range and the Bears are solidly at 2.80%. Should yields continue to move higher, it’s a sign the Bulls aren’t very convicted about their position. Should yields fall below 2.80%, look for the Bears to rapidly exit their short position.

Should this level hold, it will be a strong message to the bond Bears that the Bulls are holding. Tomorrow the U.S. Treasury is reopening a previous 10-year Treasury note auction. The results of the auction will be closely watched by both the Bulls and Bears.

Today’s $35 billion three-year Treasury auction saw yields hit their highest level since May 2008! Demand for the auction was decent. Clearly, the higher yield is a function of investors demanding a higher coupon rate as the Fed is still on a path to higher bond yields.

  1. What happened to the stock market on Wednesday?

Stocks slide in early trading but bounced on news that the U.S. was reaching out to China for a new round of trade talks. Most likely this is an olive branch before the Trump Administration slaps another round of tariffs on China. As quickly as the markets moved up, they began to fade the news.

Treasury yields began sliding in overnight trading and for the moment, have a lower high than back in June and August. An early sign that recent buyers aren’t turning into sellers.

The Producer Price Index (PPI) fell -0.1% MoM for the first time in 18 months. On a year-over-year basis, the PPI rose to +2.8%, missing expectations of a +3.2% increase. Producers are struggling to pass higher prices onto consumers. The PPI is correlated to the growth rate of the money supply, and as the money supply continues its multi-year deceleration, the PPI should too begin decelerating. A potential indicator that deflation is coming.

The EIA reported that crude inventories fell, while gas and distillate inventories rose last week. The continued increase in gas and distillates is a potential early warning that oil inventories are soon to rise. WTI oil prices were back above $70/barrel on the news.

While the stock market is excited over the +210k Nonfarm Payroll report for August, the Household Survey shows something completely different. The Civilian Labor Force declined by -469k people from July to August. The number of employed fell -423k and those not in the labor force fell -700k.

According to the Household Survey, the economy lost over 1 million jobs compared to the +210k from the payroll report. Given the Bureau of Labor Statistics publishes both numbers, it puts into question how the payrolls report can continually show gains against the household survey.

The stock market was flat for the day on above average volumes. Apple’s new iPhones weren’t enough to push Apple stock to new all-time highs.

Treasury yields were down slightly on the day. This week will be the second largest Treasury auction in history, with $73 billion being sold off. Today’s reopening of last month’s 10-year Treasury auction saw very strong interest from foreign investors. Foreign bidders took over 64% of the auction, which should continue to put pressure on all the Treasury short-sellers.

Physical gold and the large gold miners were both up today as sellers haven’t been able to push prices lower. One day does not change the trend. I still think there’s one, maybe two more moves down before a bottom is set. I continue to monitor the situation daily.

Agricultural commodities were up slightly in early trading, then shot up on news of a potential trade talk with China, then quickly faded. Buyers stepped in to push prices up in late trading.

  1. What happened to the stock market on Thursday?

Asian markets surged higher as foreign investors felt optimistic about the potential for renewed trade talks between the U.S. and China. This also pushed U.S. stocks higher at open, as the major indices “gapped” up above an overhead resistance level. The optimism over settling the trade dispute was quickly shot down by President Trump, but the stock market has largely ignored the news as buyers seem happy that stocks are moving higher.

Treasury short-sellers came in strong this morning after the Consumer Price Index (CPI) came in at +2.7% YoY vs expectations of a +2.8% print pushed Treasury yields lower. Yields slid as today’s 30-year Treasury auction saw strong foreign demand for U.S. debt.

Real average hourly earnings increased +0.2% in August, which is the first increase in the past four months. Consumer prices are still rising faster than wages.

Stocks held their gains for the day and Treasury yields were flat on the day as short-sellers came back to push yields back up. The economic data is not confirming higher yields but those betting against the Treasury market need to see higher bond yields to avoid a massive short-squeeze.

The growth rate of the money supply increased slightly from 4.02% YoY to 4.07% YoY but should resume its deceleration as the Fed ramps up its tightening.

Physical gold got rejected at its overhead 50-day moving average and fell, along with the large gold miner which gave up some of yesterday’s gains. This supports my view that there will be at least one more move down before a bottom is formed.

Agricultural commodities continue to show signs of a bottom as short-sellers are having difficulty pushing prices further down.

  1. What happened to the stock market on Friday?

Retail Sales came in at +0.1% MoM which is below expectations of a +0.4% MoM gain. Excluding autos, retail sales were expected to rise by +0.5% MoM but only managed a +0.3% MoM gain. Core Retail Sales also missed analysts’ expectations by showing a +0.1% gain for the month of August.

One might think stocks and Treasury yields would fall on this news, but the opposite happened. Stocks rose slightly in early trading before the news broke that President Trump wants to enact another round of $200 billion in tariffs against China.

Treasury yields rose until the 10-year yield tagged 3%, which is a spot Treasury Bulls have been buying bonds at. I believe this recent run-up in yields from 2.8% to 3.0% has more to do with the Treasury Bulls wanting to buy at 3%, so they are allowing the Bears to push yields up a bit. Bears need yields to push past 3.0% while Bulls want to see yields below 2.8%.

Stocks shrugged off the news that there may be another round of tariffs coming for China, but when there are large price-insensitive buyers, it doesn’t really matter.

As long as corporations continue to pump money into share buybacks, the stock market will seemingly ignore any bad news. As of September 1st, there is only $150 billion of pledged share buybacks out of the $1 trillion for the year. Once this money dries up, the market will react to bad news.

Yields fell on the tariff news, then short-sellers pushed back. Ten-year Treasury yields closed below 3% as buyers stepped in to keep yields from rising further.

Volatility has been crushed for the fifth time this week, but stock prices aren’t reacting like they once were. Given stocks and volatility are usually inversely correlated, this could be a sign that stocks may not have much more room to rise.

Despite some hope gold would rally, physical gold closed under $1,200/oz and the large gold miners fell as well. While there have been buyers in the mining sector lately, there haven’t been enough to fend off the short-sellers.

Agricultural commodities were down slightly but are showing continued signs of a bottom. The 50day moving average is starting to bottom out, which suggests prices will try to break above its 50-DMA soon. With prices flat for a month now, this is a good sign that sellers may be exhausted.