FSU Editorial: "Net Commercials and The Market Decline" by James West 03/19/2007

NET COMMERCIALS AND THE MARKET DECLINE
by James West
buythebottom.com
forever a student of the markets
March 19, 2007

Commitments of Traders 101: When commercial players � the smart money � are on the move, it is prudent for investors to take note. History tells us that commercials tend to be on the right side of the market the majority of the time. They also tend to control the majority of the open-interest in any given market, and are consequently large enough to create trends.

When the stock market tanked on February 27, many investors were caught off-guard. The mainstream blamed the earlier decline in the Asian markets as well as the technological glitch at the NYSE. These are what I call triggers; they are not in and of themselves the reason why the market sold off. Instead, the market declined because it was setup to decline from a commercial perspective. In other words, in the months leading up to the decline commercials were sellers. They sold into strength, as all the trend-followers and the dumb-money were buying near the top. When there is evidence of commercial distribution, that means that the floor or support for the market is waning and a trend-reversal is forthcoming. (Assuming that the market was in an uptrend while the commercial distribution or selling was taking place)

Notice the word �forthcoming� from the above paragraph. We are not trying to predict when the market will turn, instead we realize that there are a set of conditions present that typically lead to a trend reversal. Just because a market is setup one way or the other does not mean it will turn when you expect it to turn. In fact, it will turn when it is ready - regardless of your expectations or perceptions. The markets are a living-system; at any moment there are a thousand pieces of information � also known as chaos - that influence millions of investor�s decisions. The key that I am trying to get across is that we do not exactly know when we will see that �trigger� or �spark� that will get the ball rolling down the track a.k.a. trend reversal. We saw it on February 27, but we could have just as easily witnessed it the week before. I cannot say that I was not surprised by the market's swift decline, but on the same token, as evidenced from the COT reports, it was a foreshadowed event. It is also important to be aware that the decline was forecasted (by COT data), but not the specifics: such as the extent of the decline, duration, trigger etc.

Volatility Index

VIX [ http://www.buythebottom.com/vix.html ]
Commercials are notable sellers of the VIX as it broke out above key resistance near 13. This market is setup/setting up for a decline. What is very interesting right now is that a decline in the VIX is normally associated with a rise in the stock market, while the stock market � in large part � continues to remain setup for a decline.

Broad Markets

Russell 2000 [ http://www.buythebottom.com/rut.html ]
Commercials are stepping up and buying this index at the current levels: 760 � 790. This setup looks more neutral to me than anything else. From the price-chart, we tested the reaction-low at 760 last week, where the market found support and formed a double bottom. This is positive as long as we hold above 760: because if we break below this level it would signify a continuation of the down-trend. On the upside, there is resistance at 790 and 800; if we do not break above these levels while holding support at 760 that would translate into a range-bound or sideways market for the near term.

S&P 500 [ http://www.buythebottom.com/spx.html ]
Here once again, commercials are buyers of the recent decline. The COT setup is neutral to slightly bullish, as the net-commercial position (orange line) was range bound between -40,000 and -50,000 for several months and is now finally moving up above -40 000 representing commercial interest on the long side. Watch for a price-confirmation of breakouts / breakdowns, with near-term support at roughly 1,372 and resistance at roughly 1,410.

NASDAQ 100 [ http://www.buythebottom.com/ndx.html ]
While the RUT and SPX look like they are �improving� from a COT point of view, the Nasdaq is at the opposite end of that scale. After February�s decline, net-commercial position decreased even further to -16,678: a level not seen since March of 2006. This is as bearish as it gets in regards to COT setups, and I just do not see anything to be constructive about with respect to this index. On the price-chart, a close above 1775 might make me less bearish, but it is still hard to argue with this commercial-setup to the downside. Critical support is at 1,710.

Dow Jones [ http://www.buythebottom.com/indu.html ]
The Dow Jones looks much more like the NDX than the SPX and RUT. Net-commercial position is virtually unchanged after February�s sell off. In other words, the setup remains unchanged, and continues to point to the downside. Critical support is at 12,000. (Resistance is at 12,330)

Overall, the stock-market looks vulnerable: I would pay close attention to the Nasdaq-100, as this was the lagging index prior to the sell-off in February and right now the NDX is the weakest looking index in terms of its COT setup. The SPX and the RUT are somewhat constructive while the INDU remains negative. And finally, the VIX looks like it is setting up for a decline�and a declining VIX corresponds to a rising stock-market. So there is no shortage of mixed signals here, I would watch key support/resistance levels for clues until we see some sort of development either in price or COT data.

Commodities

Crude Oil [ http://www.buythebottom.com/wtic.html ]
While oil has been in an uptrend over the last 2 months, commercials were sellers in the market.

Last week oil reversed to the downside and decisively broke below support at 60. The COT setup is more bearish than bullish right now, and the trend is down in the short-term (unless we break back above 60), while in the intermediate term this market is range-bound between 52 and 64. I do not think that we will see oil breakout above 64 until net-commercial position rises above 20,000. On the flip-side of the coin I do not see a breakdown below 52 unless we see net-commercial position decline to -60,000 to -80,000. It looks like we will see more short-term weakness in this market�watch for future COT data to determine whether commercials are buyers of this dip and to what extent.

Gold [ http://www.buythebottom.com/gold.html ]
Commercials were big buyers of gold last week, and now the market is range bound in the short-term between 635 and 660; this market is setting up for a move up.

It is interesting to note that from early 2007 till March, commercials were sellers of gold. This was a clear sign � to me at least � that this market is setup for a decline. We got a breakdown in late February, which was followed by a huge reversal to the upside. Yes, this was a sign of strength in the short-term, and the market rallied for several more days. But the COT setup was unchanged; this market remained setup to the downside. After a failure to close decisively above 690, gold reversed down and declined until finding support at 635. This is a great example that shows how price alone does not reveal the entire picture. Yes the trend was up, yes there was a big upside reversal following a false breakdown, but at the end of the day the smart-money was getting out and that is worth paying attention to. As for the reversal, it is important to note that it supported the existing trend versus being a counter-trend reversal which tends to be more of reliable signal.

Currencies

US Dollar [ http://www.buythebottom.com/usd.html ]
When net-commercial position hit 12,000 two weeks ago, this market was ready for a rally. In the week that followed, the market started to move up, only to break down. What happens within the next few weeks is going to be critical. The COT setup is bullish, and we are near support at 82.5 on the price-chart. Over the last year, the USD has been � for the most part � in a down trend (lower lows, lower highs), so if we can make a double bottom at 82.5, we may potentially see a significant leg-up.

What I found very interesting in late 2006, is that commercials were (or at least I think they were) supportive of range-bound trading for the USD. When this index tested 87-87.5 for a second time in October, commercials were very big sellers. And when the index declined to 82.5 commercials were very big buyers. On a longer-term basis this index is range-bound for over three years now, between 81 and 92.

Regards,
James

Contact Information
James West
www.buythebottom.com
Toronto, Ontario, Canada
Email: westjam @ gmail.com (Remove the space before and after @ when sending your email)