Is Smart Money Confused?

David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates wrote an op-ed for the Financial Post, If you think this market is confusing, wait until you see what the ‘smart money’ is doing:
Okay, this really is one weird market.

I am looking at the hedge fund proxy market positioning from the latest Commitments of Traders report from the Commodity Futures Trading Commission, and the results are startling. I’m quite sure I have not seen such levels of confidence on one hand, and cognitive dissonance on the other, before in my entire professional life (and that spans 30 years).

First, there is a very large net speculative long position on the Chicago Board of Trade (CBOT) with respect to the 10-year U.S. Treasury note — a 96,007 futures and option contract net long position to be exact.

This has doubled since the aftermath of the Brexit vote, and this congestion may well be the reason why yields have stopped going down (actually up 25 basis points from the nearby lows) — the buying power has been exhausted.

The speculators have been net long the U.S. Treasury market each and every week since June 14th. Once these trapped longs exit the market, it will be safe to dip your toes back in but not likely before.

Yet, at the same time, the net speculative position on 30-day Fed funds has gone short — to 96,712 futures and options contracts from 31,600 at the end of June, so if anything, the hedge funds have become more convinced that the Fed is going to hike. And yet, they have also stepped up their long positions on the 10-year note.

Maybe they think the Fed goes, but it will be a mistake and send the economy back into a deflationary downturn.

But how can that be the case when this same “smart money” crowd has built up a net speculative long position in the S&P 500 to the tune of 28,809 futures and options contracts?

This net long position has nearly doubled since late June and you have to go all the way back to April 26th to find the last time that these folks were net short. The net speculative position on the CBOT in terms of the Dow has soared to a record 38,382 futures and options contracts.

As for the NASDAQ, the net speculative longs have nearly tripled since late June to 26,014 net speculative futures and options contracts, a level only surpassed a handful of times in the past. To say that market positioning is wildly extreme right now would be an understatement.

The “greed” factor is also highly evident on the Chicago Board Options Exchange (CBOE) where net speculative shorts on the VIX have reached 114,603 futures and option contracts, a level reached only once before. The bull market is in complacency.

But this begs the question, if there is no fear, then how is it that the net speculative position on gold on the COMEX is back near an all-time high of 326,264 futures and options contracts?

Rare is the day that record net longs here coincide with record net longs in the Dow. Ditto for silver, where the net speculative long position has soared to an unheard-of 96,782 futures and options contracts.

And yet, even with these commodities priced in U.S. dollars, the net speculative position on the trade-weighted dollar itself is 15,560 futures and options contracts on the Intercontinental Exchange (ICE).

So you see what I mean by cognitive dissonance, right?

Long bonds, short the Fed funds futures. Long equities but long bonds. Long gold but long equities. Long the dollar and long the precious metals.

At the same time, if risk appetite is so acute, why then are these people long the U.S. market and the large caps and at the same time short the emerging market equity space (which is outperforming by the way) with a net short position of 13,319 futures and options contracts (highest in 15 months) and a net short position on the small caps (1,948 futures & options contracts on the Russell 2000 on the ICE)?

It is next to impossible to make sense out of this; I’m not even sure Graham or Dodd could if they were still alive.

And this also seems surreal with respect to the Canadian economy. An economy contracting at roughly a two per cent annual rate. More than 100,000 full-time jobs lost in the past two months. A record-high $40 billion trade deficit. Exports sagging at a 20 per cent annual rate. About 30 per cent odds of a Bank of Canada rate cut priced in. A housing bubble so pernicious that British Columbia boosted the land transfer tax to 15 per cent for non-residents. And no Olympic gold medal just yet, either.

And yet here we have a situation where the net speculative position on the Canadian dollar has almost doubled in the past five weeks to 19,237 futures and options contracts on the Chicago Mercantile Exchange.

You have go all the way back to April 5th to see the last time the “smart money” was net short the loonie. My big concern is that this money has turned a bit “dumb” on this bet.
I waited till after the close on Thursday to post my comment. Let's see how markets fared today (click on image):

You'll notice stocks were up, oil (USO) was up big (4%), gold (GLD) and silver (SLV) were both down, the US dollar gained on the euro, pound and yen but lost versus the CAD (because oil prices surged), the volatility (fear) index (VIX) got crushed and the yield on the 10-year Treasury note backed up 6 basis points to 1.57% as long bonds (TLT) sold off.

Not exactly the cognitive dissonance that Rosenberg was talking about in his article. Everything seems fine except the rally in oil when the US dollar is rallying relative to the yen, pound and euro, not the loonie which is basically a petro currency (however, lately you see weird moves even there, like the loonie rallying when oil prices are declining).

Now, let's look at the performance of various exchange-traded funds (ETFs) I track as of the close on Thursday (click on image):

Here you'll notice emerging market shares (EEM) are making new 52-week highs led by Chinese shares (FXI), which suggests funds betting on a global recovery are doing very well this year.

[Note: Emerging markets and oil are intrinsically linked. Read Liam Denning's article on the emerging market debt bomb ticks for oil.]

You will also notice momentum in semiconductors (SMH) remains strong but it's starting to weaken in REITs (IYR) and utilities (XLU) as yields back up but that of homebuilders (XHB) remains strong which tells you investors aren't scared that higher rates will curb demand for new homes (or maybe they don't think higher rates are here to stay).

Clearly the market is sending a signal that global growth is on track and funds that bet big on a global recovery last year are enjoying nice gains this year following the washout at the beginning of the year. In fact, look at a small sample of stocks leveraged to global growth which I track (click on image):

Most of these energy, mining and metal stocks are up on days when oil surges because when oil prices go up, it sends the signal that the global economy is doing well. And look at Industrials, they are also soaring, with many stocks near their 52-week highs (click on image):

This too suggests the global economy is doing much better than most skeptics think.

The problem is there's so much algorithmic trading going on in these extremely volatile markets that you don't know what to believe as prices gyrate around a lot week to week, day to day and even intra-day.

But right now, there clearly is a pro growth bias going in the markets and that's why gold and the VIX sold off today, yields backed up, emerging markets made new 52-week highs, and both oil and the Canadian dollar rallied sharply.

The problem I have with all this? If the US dollar doesn't stumble and keeps rallying relative to the yen and euro, then how much more upside do oil oil and other commodities have? Deflation is ravaging the Eurozone and Japan and pretty soon it will catch up to emerging markets too.

Go back to read my recent comment questioning the wisdom on selling everything but gold. I explained why given my bullish USD views, I wouldn't touch gold, especially after the big run-up this year and why I remain short commodity currencies and emerging market stocks (EEM), bonds and currencies. I also explain why I continue to recommend the biotech sector (IBB and XBI) and see it continuing to gain in the months ahead heading into the US election and beyond but it will be volatile.

Lastly, given my views on global deflation, I'm less bullish on financials (XLF) and continue to recommend hedging your portfolio using good old US bonds (TLT), the ultimate diversifier in a deflationary world.

On this last point, global bonds have entered the twilight zone but the bond market's ominous warning is still lurking in the background even if stocks are at record highs. Too many investors mistakenly dismiss this as part of the "search for carry" distorting US bond prices, but maybe there isn't any big illusion in the bond market, maybe there is a more fundamental, pernicious factor driving yields to record lows (like the deflation tsunami I warned of at the beginning of the year).

All this to say while I understand David Rosenberg's frustration in analyzing these markets using a fundamental approach, I remind him and others that markets, especially these algorithmic, schizoid markets, aren't there to make sense, they're there to inflict maximum frustration on the maximum amount of investors.

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Below, permabull Tom Lee, Fundstrat Global Advisors, weighs in on what low bond yields indicate and why investors need to start thinking about growth trades.

Notice how he dismisses low bond yields as the global "search for carry" and even states that "inflation is underpriced in the markets"? Yeah, sure, tell that to the bond market.