Inside track

PORTFOLIO POINT: Traders have trimmed their long positions in equities, but they're resisting market moves – meaning that if Europe stabilises, the rebound could be faster and much stronger than in the past.

I thought it might be interesting this week to see what one subset of the market, professional traders, are doing. I’m not talking about what their strategists and economists are saying, but what the traders themselves are doing and what, if anything, we can learn from it. In doing so, I’ll refrain from offering too much of an interpretation as to why exactly traders have the positions they do, but I will offer a view as to what their positions might mean for the market more broadly.

Looking first at equities, the recent flare-up in European concerns has seen stocks sold down about 7% on the S&P500. From a peak in late March, the All Ords has come off about 9%. Now if you missed this turnaround in sentiment, you’re not alone, and shouldn’t feel too bad about it. Data from the CFTC (Chart 1 below) shows that the professional traders or speculators also missed it. The chart shows S&P500 futures (rebased to an index of 100 for charting purposes) in red and the net long/short positions of traders, provided by the CFTC, in blue. This data isn’t perfect in telling you where traders have their money, and it’s not telling you what real money managers – fund managers – are doing. But the data can provide a good guide to market sentiment – a better guide than anything else I've seen – and it is well respected. It’s important to note at this point that the data excludes positions used for hedging; it simply shows positions used for trading or speculation in the futures and options market.

Now the chart below shows that traders had largely been short equities throughout the rally leading up to the March 30 peak, and had only just gone long when the sell-off came.

Chart 1: Net long/short positions of traders and S&P500 equity futures

People were, by and large, caught unawares by the sell-off. What’s interesting to note is that having been caught unawares, even with the odds over a 'Grexit’ increasing, traders still haven’t abandoned their long positions, which is especially interesting when you see where traders have come from in Chart 2.

Chart 2: Net long/short positions of traders and S&P500 equity futures

Just looking at the blue line for a moment, one of the stand-outs is just how short traders have been over the last 36 months or so. They haven’t needed much of an excuse to short the market and indeed, for most of 2010 and 2011 (around 20 of those 24 months), the market was short – and not just short, but short with conviction. You can get a sense of the conviction of each position by the height of the peaks and the depth of the troughs. That the market more broadly was up some 15% at that point doesn’t necessarily mean traders didn’t make money. Timing is everything, and I’ve circled some points where traders either reduced shorts into an upswing, or extended them as the market fell.

So with that in mind, and even after the elections in Greece and the ensuing 7% fall in stocks, traders are still long! I was very surprised to see this, to be honest. Admittedly, they’re not long with conviction – the peak is very low and long positions were reduced over the last week. But the fact they’re long at all, when they’ve spent the bulk of the last two years short, tells me that traders are less worried this time around; they’re a little more relaxed about some of the Armageddon-type scenarios. This is a very big shift in market psychology, and perhaps that’s why the market drop this time around is comparatively minor at 7% now, against 17% in early-mid 2010 and 20% mid last year. Is this a possible sign of Greek fatigue setting in?

What about the bond market? The bond market has been a cause of pain for many real money managers and traders alike. And you can see why, as they have been very short through what has been the largest bond rally in history. Again, that’s not to say that traders haven’t made money (as the chart shows); they’ve correctly reduced shorts into a rally (2010), and gone long into one or shorted at the correct time (early to mid-2011). But as a general rule, the market sees value in being short, given that yields are at record lows through much of the developed world. (The situation has given rise to the notion of a 'bond bubble'.) It’s a particularly difficult market to trade when you have governments intervening so heavily in the market. The US Federal Reserve, for instance, is the single biggest holder of US treasuries. Traders are still not on board the rally though – look at the divergence between treasury futures (or the 10-year yield) and the positions of traders (far right of chart). The gap is the largest it has been for some time and traders are short with some serious conviction. Remember, these are not hedging positions.

Chart 3: Net long/short position of traders and 10-year Treasury futures

Traders have reduced those short positions somewhat, sure, but the positions are being held, despite a drop in yields. This would seem to suggest that traders think the rally is overdone and are positioned for a big correction. This shows the importance of ongoing quantitative easing programs by central banks in keeping yields low – without QE, traders will likely get that correction. And really, that is the biggest influence on the market at the moment – central banks and their willingness to print. Traders seem to think there is a limit.

While equities and bonds are positioned for a more buoyant global economy, it’s when we look at how traders are positioned in the commodity and currency markets that the picture is a little more cloudy.
'Dr Copper’, so called because of its apparent ability to lead the cycle as a bellwether commodity, is a case in point.

Chart 4: Net long/short position of traders and NYMEX copper futures

You can see from the chart that the relationship between market pricing and trading positions is very strong. People can argue over causality (graphically, you can see that there are points where each leads the other), but the relationship is a good one. You can also see from the chart that traders have recently gone short. Conviction isn’t that strong, though, and they’ve come out of a period where traders have generally been long (2009-mid 2011) – and right! There is no shortage of reasons for the change – concerns about growth in China, events in Greece, etc. But the point is, there is a decidedly more bearish tone to things here in comparison to the bond and equity markets.

It’s a similar story with the AUD; traders, having been very long on the currency, have only recently become bearish on the AUD for the first time since the GFC (although again not with a lot of conviction).

Chart 5: Net long/short position of traders and AUD

But the fact that this is the first time traders have gone short suggests that the dip below parity may have more longevity about it. Consider that the last few times the unit fell below parity, traders remained long and the dip proved short-lived. Not so this time – traders are short and that is a significant change, and not necessarily due to domestic factors alone. You can see this is the case because the change in sentiment seems to have occurred around the same time as the change in sentiment on copper, and also accompanied a spike in long positions on the USD (Chart 6 below), so there is a global element to it.

Chart 6: Net long/short position of traders and USD

That said, we’re not seeing a broad-based pessimism across the commodity spectrum (check out Charts 7 and 8). Traders have been and continue to be very long crude and gold.

Chart 7: Net long/short position of traders and gold
Chart 8: Net long/short position of traders and crude (WTI)

In summary, traders have a few strong conviction calls – crude, gold and bonds – but don’t appear to have many strong conviction calls outside of those. In the equity space, traders have trimmed long positions, but appear to be resisting market moves for the first time in years. The implication is that if the situation in Europe stabilises (which could be brought on perhaps by Syriza failing to gain a majority in Greek elections), then the equity rebound this time could be more rapid and much stronger than in past episodes. In the bond market, traders are telling us that there is a limit to further quantitative easing and have maintained their strong short positions in the face of this latest rally. In the absence of further central bank action, the pressure is for yields to rise. In the currency space, moves are more confusing, but traders appear to be of the view that the recent dip in AUD may have some longevity.