I've got a question. I did some statistical analysis to draw a correlation between the weekly change in the value of the S&P 500 and the percentage net long positions of the three trader classes (for my paper at school) and I came up with something that confuses me. Maybe you can help me in my thought process. According to my test, the commercials have a negative relationship with the percentage change in the S&P 500. In other words, when the commercials positions get longer (less short), the S&P falls, and visa versa. Even weirder, the test for the non-reportables is exactly opposite. My first thought was that I did something wrong, but I think I may have thought of something that supports it. The commercials are mostly hedgers, right? So if they are going short in the futures markets, they are probably going long in the equities markets. And if they are long in the equity markets, then they are probably driving prices up. This would make sense (if I'm right) with what I found in my analysis. The problem is, it seems to contradict the rest of my paper, which is mostly based on what you have written in the Smart Monet Report (long when they're long, short when they're short). If you have a free minute to help me sort this out, I would be very appreciative.
I would have to see your data to explain what you’re seeing because from what I understand you’re saying is that historically the non-reportables have been reliably on the right side of the market and the commercials have been on the wrong side of the market. Nothing could be further from the truth. It’s just the opposite. Just to give you an example, the big bull market of the ‘90’s really accelerated in January of 1995. At that time, the commercials were very heavily long S&P futures and the non-reportables were very heavily short. Or in January 2001, right before the market took a huge dive, the commercials were heavily short and the non-reportables were heavily long. I’m probably misunderstanding what you’re saying. Perhaps you could give me an example.
Now let’s examine you’re hedging theory. First of all, it’s very difficult to paint the motivations of commercial traders in using the futures markets with a broad brush. They use the futures markets for different reasons. But for simplicity sake, let’s just consider the ones who are using the futures markets to hedge their stock portfolio. You’re right when you say that they would have a short position in futures at the same time that they would have a long position in stocks.
But the question is when are they going to decide when to hedge and when not to hedge? And how are they going to decide how much of their portfolio to hedge? Commercial traders in S&P futures are not like farmers hedging their crops in corn or soybeans. A farmer is just trying to lock in a profit margin. So a farmer may be hedged at all times (very few are but that’s another story) and short the futures markets at all times. But a stock is not like a commodity. If a commercial trader of a financial institution stayed 100% hedged at all times there wouldn’t be any way to make money unless he were able to find an arbitrage between the futures and the cash. And as efficient as the markets have become arbitrage opportunities would be relatively rare. So he is likely going to make a decision to hedge or not to hedge and how much to hedge by whether he thinks stock prices are relatively high or relatively low. If he thinks prices are relatively low, he will hedge less. If he thinks they are relatively high he will hedge more. In other words, in my opinion, even hedgers are expressing an opinion about market direction through their futures activities.
I have never been able to identify a correlation between stock prices and the degree that commercial traders are net long or short except when it gets to be extreme. There does seem to be value in going long the market when commercial traders are the most long (or the least short) than they have been over a long period of time and going short the market when the commercials are the most short (or least long) over a long period of time. Other than tracking their switches from net long to net short (and vice versa) those periods of extreme positions are the only ones I’ve found to be of any real value.
Larry
Re: confused
November 7 2003, 9:08 AM
That makes sense, I just needed to hear it from somebody else to sort it out in my head (it's easy to get lost in a mound of data). I think there are some flaws in my model that I need to work out, or like you said, it may not be possible to draw that correlation except for at extremes. I'll be done with my paper early next week and I'll e-mail you a copy. Thanks again for all your help.