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Chart In Focus

Commercial Traders Foretell Market’s Movements

Chart In Focus
May 27, 2011

There are some informational jewels in the CFTC's weekly Commitment of Traders (COT) Report, and sometimes in ways that most people would not imagine.  This week's chart looks at data on commercial traders' net positions in eurodollar futures, but with a twist: that data is shifted forward by one year to reveal that it actually leads the movements of the stock market.

Readers of our twice monthly newsletter are already familiar with this relationship, since we have been showing it regularly in that publication.  It is one of the more interesting and powerful leading indications we have discovered.  If you are not currently a subscriber to that publication, now would be a good time to sign up  to see this and other insights about what lies ahead for the stock, bond, and gold markets. 

The term "eurodollars" should not be confused with the exchange rate between the dollar and the euro.  It refers to dollar denominated time deposits in European banks, and the term predates the creation of the euro currency.  Eurodollar deposits typically follow the LIBOR interest rates.

The CFTC classifies all futures traders as either commercial (big firms and market makers), non-commercial (large speculators), or non-reportable (small speculators).  The commercial traders are usually presumed to be the smart money, and so a lot of people who watch the COT data like to trade in sync with whatever the commercials' net position is.

The interesting point about this week's chart is that I am taking data from the eurodollar market, and applying it to an analysis of the US stock market.  The key discovery that I made a few years ago is that the movements of the SP500 tend to echo what the commercial eurodollar traders were doing previously.  I played around with alignments to get the best fit, and found that a one-year lead time gave the best correlation. 

Let's pause a minute to let that deep point sink in.  Commercial eurodollar traders seem to "know" a year in advance what the stock market is going to do.  It is not a perfect correlation, but it is a darned good one.  I'm not sure what makes this work, but I have seen that it has worked great since about 1997.  It may help to understand that the commercial traders of eurodollar futures are typically the big banks, who are using these futures contracts to manage their assets and fund flows.  So what we are seeing in their futures trading are responses to immediate banking liquidity conditions, and those actions give us a glimpse of future liquidity conditions for the stock market.  These liquidity conditions are revealed first in the banking system, and then the liquidity waves travel through the stock market a year later.  But even if we cannot identify exactly what makes something work, after a few years of seeing that it does work we can learn to accept it. 

The reason I picked this chart to show this week is that it is shouting to us now that something big is coming up for the stock market between June and October.  In June 2010, the commercial eurodollar futures traders had gotten all the way up to a neutral position overall.  Then between June and October 2010, they moved back to a big net short position.  You can look back at the left end of the chart to see what it means to have the commercials move toward a bigger net short position. 

It just so happens that this indication of a big top due in early June coincides with the end of positive annual seasonality in June every year, and also the end of the Fed's QE2 program.  So the market is going to have two bullish factors (seasonality and POMOs) expiring at the same time that this chart's indication of banking liquidity flows says that the stock market is about to enter an illiquid period.  Yikes!

The good news for the bullish case is that once that October low is put in, this eurodollar leading indication says we should see a really strong rally into the end of the year.  But we'll have to get through some rough months this summer before it is time to play that year-end rally. 

Tom McClellan
Editor, The McClellan Market Report

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