How you can avoid getting sucked in by soaring stock market speculation

Average investors must weigh outcomes if plans fall through, writes Martin Pelletier.

Like a casino, the market at times can be filled with speculators placing their bets on what they think will happen in the future. This typically occurs during market extremes when either negative or positive momentum takes hold of a particular commodity, currency or stock.

While some argue that these speculators provide liquidity and improve market efficiency, most agree they can also compound movements to both the upside and downside. This can be a dangerous development for average investors, who are prone to behavioural flaws and as a result at times get sucked into either buying at market tops or selling at market bottoms.

For example, an investor may look at a large speculator long position as confirmation that the underlying will continue to move higher or vice versa on a large short position. The problem is that in fact these positions provide no assurance whatsoever of future direction but instead simply reflect what speculators “believe” is going to happen.

Just like the bookies who placed odds on the Brexit result or the probability of Donald Trump becoming president, they too can get it very wrong and when positions suddenly unwind it can result in large corrections.

For the contrarian it can therefore be very useful to watch for new highs being set in either speculative long or short positions. The weekly Commitments of Traders report is a great place to start as it shows the open interest of traders classified as commercial traders who use the futures market to hedge and non-commercial traders who use it to speculate.

In today’s environment, it isn’t surprising to see speculator positions herded around the theme of inflation and higher interest rates in the U.S., especially since the election of Trump. This is evident in the current non-commercial positions in the dollar, the S&P 500, Treasuries and perhaps even crude oil.

According to the latest U.S. Commodity Futures Trading Commission (CFTC) report (March 7), the value of the U.S. dollar’s net long position reached its highest level since early February. The non-commercial short position has fallen near the record lows reached in July 2015 and July 2012 while the long position has given back some of its November highs but remains nearly double its pre-election low.

Speculators are also expressing strong conviction that the Fed will finally begin a series of rate hikes this year that will continue to cause trouble for the bond market. For example, the short position on 10-year U.S. Treasuries is now more than five times higher than its November 2008 lows and has never in its entire history reached such extreme levels.

Meanwhile, speculators remain confident that the S&P 500 will continue its upward trajectory with non-commercial net long positions reaching 137,600 contracts, which was a huge reversal from its February 2016 net short position of 139,300 contracts.

Finally, the most interesting reports by far have been in crude oil, with speculators setting new records for long positions at an astounding 500,500 contracts, which is just off of its recent alltime high of 556,600 contracts on the Feb. 24 report. To add some perspective, from 1995 to 2010 the non-commercial net position averaged only +/- 50,000 contracts, so the latest figures are an order of magnitude greater.

In summary, bookies are expecting a moderately higher U.S. dollar, stronger U.S. equity markets, significantly higher oil prices, and an outright collapse in the bond market.

In our opinion, before placing your bet perhaps it’s worth asking what happens if any of these outcomes fail to materialize. Hedging your investments by taking the other side, as a commercial trader would, might be the best bet of all during such market extremes.

Financial Post Martin Pelletier, CFA is a Portfolio Manager and OCIO at Trivest Wealth Counsel Ltd, a Calgarybased private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.