Spec-tacular

Yogi Berra, a colourful figure from baseball's past, was a better than average ball player. He also happened to be on great teams, the '50s Yankees, featuring the likes of Mantle, Maris and DiMaggio. But he was most famous in later years for offering up linguistic non sequiturs that strangely made sense.

He once famously said of a New York restaurant, "Nobody goes there anymore, it's too crowded".

In markets, speculative trading usually involves a fair degree of short term-ism. Chasing the winning trade is the common fault of many investors. As the trade becomes popular, this tends to create a dangerous situation - the "crowded trade".

Late last year, the most crowded trade was in the 'low vol' funds. It was strikingly a similar strategy to an options buy-write stock trade, only on a much larger scale. 'Short volatility' funds had amazingly consistent positive returns, engendering a dangerous confidence that abruptly and spectacularly fell apart in January of this year. ( re-read my Jan 17th blog "Rogue Wave")

As usual, it was obvious in hindsight. The trade had become 'crowded'.

The data on speculative positioning is often helpful in determining the degree of fervour that accompanies strong moves in financial markets. Despite the strength of your conviction, it always pays to observe the behaviour of the crowd.

Let's look at the current crop of crowded trades. The CFTC (Commodity Futures Trading Commision) charts provides weekly Commitment of Traders data that can be used to analyze trader positions. Below, I show the 'Large Speculators' levels juxtaposed with the corresponding price/yield level.

The Euro

As relative global growth rates diverged in favour of the eurozone mid-last year, and ECB monetary policy reversals were postulated, Europe seemed to be a good bet last year. The crowd jumped in. The single currency jurisdiction looked like greener pastures for the currency traders weary of Trump's shenanigans.

Fast forward to last month, when economic surprises turned sharply lower and geopolitics turned hostile (Italy went decidedly populist). The previously winning trade, long Euro, was quickly on the back foot.

U.S. 10 yr Treasuries

The widely-held view that yields have broken a secular downtrend is now firmly entrenched in the minds of most investors. The chart above shows how completely traders have embraced that view. Shown in the inverse position on the chart, there is now a record short position in bonds, a bet on rising yields, held by speculative holders. To me, this should help to dampen the upward march of bond yields, despite the supportive fundamentals of higher inflation and increased net supply.

And finally...

Crude Oil

The threat of supply shortfalls from Iran and Venezuela have driven a massive increase in the speculative long crude positions to levels not seen in years. Faced with a surprisingly disciplined OPEC cartel, under-positioned investors, who last year left the sector for dead, have exhibited renewed interest in this previously shunned market.

However, there is now plenty to worry about as this crowded trade has morphed into a dangerously speculative front page driven phase.

I have argued that there is always risk in owning a commodity that is trading significantly above its marginal cost of production. The production of any asset generating revenues far in excess of its' cost will inevitably induce increased production of that asset. As the chart below shows, there is now plenty of low cost oil to be produced, given the collapsed cost curves worldwide.

Finding and Developing costs are the ultimate arbiter of oil prices. The cure for high oil prices is high oil prices. Look for a retrenchment phase to develop on any threat of OPEC disunity. I expect Russia to break ranks first.

I have previously argued that commodities are a great diversifying asset in the current environment. Capacity additions have been stunted by restrained capital investment and investors are massively under weight.

The restraint shown by oil companies over the last two years is well documented. They are unable (pipeline constraints) or unwilling (divestitures, buy-backs and divy hikes) to reinvest in increased cap-ex at a rate that was prevalent in the $100/bbl era.

I have also argued that the portfolio rebalancing from the low-vol trade would benefit cyclicals and resource stocks that are so under-owned. I was long Suncor and short Enbridge as an example.

I believe that as we approach quarter-end next month, and with the best of seasonality behind us, there is a risk of the popular and crowded trade unravelling a just a bit. As the Euro, 10yr Treasuries and oil trades now all exhibit a bit of crowded behaviour, it may be prudent to be somewhat more circumspect.

This economic cycle, extended as it is, has been characterized by a slower than expected expansion timeframe. The resurgent U.S. dollar should temporarily blunt the rise in inflation, leading to a 'stop-start' environment for both yields and oil prices. I smell a trade to the downside in oil. It seems investors are consistently rushing to a speculative conclusion these days. Reality is moving much more slowly.

Yogi was often right in his convoluted way. When it comes to following the spec traders he might have said "you can observe a lot by watching".

Risk Model: 4/5 - Risk On

The only fly in the ointment currently is a slightly over-bought (RSI 64) market. A short term pullback in the extended energy sector would help that. However, when coming out of a three month corrective base, this is normal and not concerning.

The other measures are comfortably in green mode. Notably, Copper has begun to take back leadership from gold. This relates to the tenuous Trump trade truce with China, so I will believe it when I see it. The economic slowing evident in the Eurozone has yet to reverse. Perhaps the upcoming Flash PMI data on Wednesday will provide more clues. More patience is needed, but a summer base metals trade is shaping up nicely.