The Biggest "Short" of the Year

by Guest Editorial

The Biggest "Short" of the Year

by D.R. Barton, Jr., Contributing Editor

Tuesday, October 31, 2006: Issue #598

The Dow Jones Industrial Average just keeps making new highs. In fact, it's made new all-time highs in 11 of the last 16 trading days.

The Dow is the most watched stock index in the world. It acts as the benchmark for the overall U.S. market (as in, "What's the Dow doing today?"). And the fact that it's making a string of record highs is significant.

But right now might not be the time to get caught up in the bullish fever

That's because while the Dow and the other broader market indexes push higher, there are ominous signs that point to a pullback in the markets - and sooner rather than later

The Heavy Traders Agree

One set of data that I like to use is sentiment analysis. It seeks to quantify and qualify investor sentiment to gain an understanding of what the market is likely to do next. There are many tools used for sentiment analysis - including put/call ratios, volatility measures, asset flows and sentiment surveys.

One sentiment tool I like is the Commitments of Traders Report. This comes from the Commodities Futures Trading Commission (CFTC), which collects data from all traders who trade in "reportable size" (a size above a threshold set by the CFTC).

This data can prove quite useful, especially since the CFTC separates the data into three categories: Large Speculators, Commercial Traders (those who use futures contracts in their day-to-day activity, and may have the best read of current market conditions) and Small Speculators (mainly retail traders).

So what's the big story here?

Commercial traders are holding their largest short position in the S&P of the past 22 months! Check it out on the chart below:

Commercial Trader Chart

This research by Bennet Sedacca of Atlantic Advisors, LLC (and reported by analyst Tom Peterson) also shows an interesting correlation of up and down moves during times when the commercial traders held extreme positions.

But that's just one early warning for us. Here's another

A Red Flag From Charles Dow Himself

Charles Dow is widely regarded as the father of technical analysis. One of the tenets of his "Dow Theory" is that when the Dow Industrial Average and the Transportation Average are at odds, the market is unstable (for more information on Dow Theory, and how it works, see today's crib sheet below).

And that's exactly what's happening. Take a look at the chart below, and you'll see that the Transports haven't been as excited as their Industrial brethren about these new highs. This type of divergence usually leads to a correction (kudos to my good friend Christopher Castroviejo for pointing out the divergence in this venerable relationship).

DOW Chart

I don't think it's time to jump ship just yet on this recent bullish run. There's a good chance we could get a "blow-off top" before this is over. But I do think we're getting clear indications that a pullback is due in the near future.

If you don't want to look at the short side and you're not fully invested, don't jump in when the market is at its most frothy point. To short this market, I think you need a clear sign that we've started to pull back (basically a couple of weak sessions on the Dow). So wait for the expected pullback to give you better entry prices.

Good trading,

D.R. Barton, Jr.

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