December Dump? It Better Happen Fast.

Bottom Line: Commercial traders in the major index futures have gathered their 2^nd-largest net short position in history in nominal dollar terms. This is an abrupt change from a few weeks ago, and may be a sign of trouble ahead.

At the November 2^nd reporting date, commercial traders in the S&P 500 futures contract were holding their most bullish positions in relation to small speculators since the March 2003 bottom. The S&P so far has followed through nicely since that time, rising more than 50 points. In the most recent report that was released today, covering positions held through last Tuesday, this positive attitude has apparently changed, and now this data is showing one of the more bearish configurations we’ve seen.

I’ve noted many times that I feel this data has become less useful since the e-mini contracts have received so much attention (and volume). However, by looking at the nominal dollar value of all positions held for both the full and e-mini contracts for the S&P 500, Nasdaq 100 and Dow Jones Industrial Average indexes, we can perhaps get a better idea of the overall outlook of these traders.

The chart below shows the total dollar value of outstanding contracts as of the last reporting date.

We can see clearly from the chart that over the past couple of weeks, commercial traders have been increasing their short-side exposure dramatically. As of last Tuesday, their net exposure was the most bearish it had been in history, except for March 6, 2001. At that time, commercials had just over $40 billion worth of futures contracts net short, as opposed to just under $38 billion now. After the 2001 instance, the S&P quickly lost about 12% of its value over the next couple of weeks, which the commercials used to dramatically reduce their short-side hedges.

The current instance isn’t quite comparable. Most notably, in March 2001 commercials were net short about 111,000 full contracts and 30,000 e-minis. Most recently, they were net short only 29,000 full contracts but 436,000 e-minis. Overall, it comes out to about the same level of net short exposure, but it’s a different distribution – in 2001, they were mostly short the full contract whereas now they are mostly short the e-mini. As for the importance of that distinction, I’m not sure. It could just be a natural migration towards a more versatile contract in the e-mini, or it could be misleading due to the same traders using both contracts to play off each other. Still, I think it’s worth mentioning as something to keep our eyes on, as the suggestion is that the market should decline after seeing readings such as this.

Bottom Line: Options traders have changed their outlook on rallies, now believing more and more that this one will last. This is in marked contrast to the skepticism seen towards higher prices in October.

In early October, I noted that according to the ISE options exchange, traders were becoming more and more leery of buying into rallies the further along the year went. Every time the broader market rallied, traders were buying to open less and less calls relative to puts. I showed a chart at the time which showed this apparent skepticism, with the assumption at the time being that this healthy sign would be a contributing factor that should limit any subsequent market declines.

I have updated that same chart below, as the sentiment expressed by these traders has changed dramatically. Instead of shying away from attempting to ride higher prices by buying calls, traders are now fully on board. Over the past five days, the ISE Sentiment Index has averaged 217, meaning that traders are buying to open more than twice as many calls as puts. The updated portion of the chart is shaded in green in the chart, and we can see that the Index (the blue line) has skyrocketed over the past few days.

The Index is above 200 for the first time since April 29^th, and is at its highest point since February 19^th. The current reading of 217 is still below the all-time high of 250 set on January 22^nd, but obviously this is a stark change from what we were seeing in October.

The ratio has room to climb higher as speculation enters a fever pitch, but even the current readings should give us pause. Supporting this view is our R.O.B.O. put/call ratio which fell to a lowly 0.38 last week. A reading that low tells us that the small options traders who buy fewer than 10 contracts at a time were more than 2.5 times as likely to buy a call option than a put option last week. Once again, this was the most speculation on higher prices we have seen since February, and while it does not indicate an imminent top, it is one more reason to suspect higher prices may not be sustainable.

Bottom Line: Any meaningful decline during December will most likely occur during the first half of the month.

If we’re going to see an appreciable decline in December, it’s most likely to happen in the beginning of the month. Over the past 53 years, the S&P 500 has shown a consistent tendency for the latter part of the month to significantly outperform the start of the month.

The table below shows several stats on how the S&P 500 has performed since 1950 during the two halves of December. The table looks at the first 10 days compared to the last 10 days (the last 10 days is a loose term – sometimes there were 11 or 12).

December’s Split Personality S&P 500 Performance by half of month, 1950-2003
	First 10 Days	Last 10 Days
Avg Return	0.1%	1.5%
% Positive	58%	80%
Largest Gain	5.2%	8.5%
Largest Loss	-8.0%	-2.8%
Gains > 3%	4	9
Losses > 3%	6	0

From the table we can see that the latter half of the month was positive a whopping 80% of the time. For nine of the years, the S&P sported a gain of more than 3% during the last half, as opposed to no losses of more than 3%. Looking at the first half, however, there were more losses of greater than 3% than there were gains of greater than 3%.

With today’s software, it’s possible to data mine historical databases and find all sorts of interesting seasonal patterns. Unfortunately, there is little reason behind most of them and they likely will not stand the test of time. With the December pattern, there are several possible explanations for why the last half of the month would outperform the beginning. It is a consistent pattern (the last half of the month has outperformed the first half for 8 out of the last 10 years), and is one that should be respected. If we are going to see any meaningful decline in December, we should see it before heading into the waning days of the month.

There are plenty of signs on our site and elsewhere that excessive speculation has made a return. Our intermediate-term score for our indicators is now down to 67%. This is the lowest reading since the beginning of January, and even during the strong uptrend since last March, the broader market has struggled to maintain gains after so many indicators were suggesting optimism was excessive. It’s difficult to fight the positive reputation that December has earned, but as noted above much of that positive momentum tends to show itself in the last part of the month. Our readings our suggesting that being aggressively long here carries significant risk, particularly over the next couple of weeks. If we can levitate through the first couple of days of the month, and our measures continue to show the types of readings they are now, I may consider taking some short exposure with the assumption that it would be covered before Christmas. If we do get some weakness if the first couple of weeks, it should once again set up a good risk/reward situation from the long side (provided more of our indicators back off their extremes).

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.