Avoid the Overbought Markets

The US stock market bounced a little yesterday…very little. And most commodity markets bounced even less, if at all.

The Dow Jones Industrial Average jumped 89 points shortly after the opening bell. But as the trading session advanced, enthusiasm for stocks waned. By the time the closing bell sounded, the Dow had gained a meager 9 points. Very meager.

Over in the commodity pits, the trading action was even more dismal. Early gains yielded to late-day losses. Gold and silver started higher, only to end lower. Most other commodities followed suit.

Mr. Market seems to have lost his pizzazz. He’ll get it back someday, but probably not immediately. Here’s why: Great big rallies tend to produce large corrections…or at least sudden, frightening corrections.

Let’s roll the videotape…

During the last two years, short-term interest rates have collapsed from a meaningful number to an invisible one. Therefore, investors dumped fixed income and bought something else…anything else. They re-directed their capital toward more promising asset classes like equities and commodities.

But the pendulum has swung too far…at least for the moment. Many equity and commodity markets are “overbought” and deserve a rest. At least that’s the informed opinion of David Rosenberg, The Daily Reckoning’s favorite economist.

In a recent missive, Rosenberg warns, “It may be time to avoid the areas of the market where net speculative long positions exist and are in the process of unwinding.” In other words, it may be time to avoid the areas of the market that have become too popular – the “crowded trades.”

Rosenberg highlights the following crowded trades:

  • Equities: There are currently 5,780 net long contracts on the Chicago Mercantile Exchange (CME).
  • Oil: There are a near-record 208,226 net long contract on the NY Mercantile Exchange.
  • Gold: There are a near-record 253,528 net long contract on the COMEX.
  • Copper: There are a near-record 25,139 net long contracts on the COMEX.
  • Silver: Not a record but a still significant 42,556 net long contracts on the COMEX.
  • Euro: Huge net speculative long position of 35,879 contracts on the CME.

At the other end of the spectrum, Rosenberg notes, volatility is cheap. “With the risk-on trade in full force for the last two months, the VIX futures have a net speculative short position of 13,345 contracts, which is at the high end of the historic range.” [The VIX is an index of implied option volatility. The higher the index, the greater the level of investor fear; the lower the index, the greater the level of investor complacency. Shorting the VIX Index is, therefore, a bet against fear – a bet that rising stock prices will remain the status quo.]

In other words, investors are very complacent, which is usually the condition that precedes market selloffs. Curiously, investor sentiment has reached bullish extremes for stocks and commodities at the same time. Traditionally, these asset classes are non-correlated. But this time around, the two have been very highly correlated. If, therefore, these two asset classes are able to rally at the same time, they are also able to correct at the same time.

Net-net, if you’re bearish on stocks or commodities, this is your moment. If you’re bullish, take your time establishing new positions.

Eric Fry
for The Daily Reckoning