Forced Selling Frenzy Forms In February

It was an interesting week in global markets, to say the least! After an over-extended period of complacency, volatility reared its ugly head, triggering forced selling that allowed some of the most crowded trades in recent memory to come unwound. Just look at Crude oil futures or the short yen trade, both of which have over 80% of speculators on one side, and both reversed quite significantly last week because of outside forces. While looking at positioning data may be backward looking, this week's Commitment of Traders (COT) report offers some insight to how things for the market may play out over the coming days and weeks.

No matter how you look at it, technicals also played a key role in this past week's price-action. First, entering this past week, most equity indices (especially the S&P 500 and the Nasdaq-100) were already in position to sell-off. Both had marked bearish key reversal patterns on weekly charts, at already eye-popping overbought levels (weekly and monthly RSI). And, with record low volatility for such an extended period of time, the markets were due for some sort of pullback.

Of course after the fact, market participants always seemed obsessed in figuring out what happened and why. For example, we learned that a record inflow of retail money was chasing equities for the month of January. For those that follow my weekly analysis, know that I often point-out that the retail trader is often too early or too late to the game, and in this case it seems to be the latter.

We also learned about these ultra-short VIX ETF or ETN's that blew-up, and apparently were behind why the market moved so much. The fact is, these instances offer-up interesting insights, but reveal nothing about what is yet to come.

Besides equities, the most crowded trades in the futures markets (according to the most recent COT report) are Oil, the short yen trade, Gold futures, and the euro. And, if you weren't hiding under a rock, you almost surely noticed that all four of these reversed hard this past week.

The problem, however, is that after last week's "Turn-around Tuesday," where the COT reported up to (February 6th), the data suggests that large speculators, who are often on the right side of the trade, had actually added long contracts for S&P 500 futures, and quite substantially from the previous weekly reading.

The bump-up in longs by speculators in S&P 500 futures, could explain why markets rallied so much off the lows twice last week. But, besides the fact that an influential segment of the trading population may be fighting the market while it sells-off, what is more worrisome, is that if there is indeed more forced selling that matriculates to other markets, the over-crowded one's (oil, short-yen, gold and euro), do indeed have a whole lot of room to go, and could usher even more unified panic selling.

That's where technical analysis comes into play, once again! The most significant technical occurrence from last week is when S&P 500 futures probed the 200-day moving average and re-tested 2528 (last Tuesday's intra-day low) while the USD/JPY tested and held up near the key Y108 figure.

The moment selling ceased at those key junctures on Friday, global markets leapt, retracing a good chunk of what it had previously lost. So, its an under-statement to say that those two support levels are extremely important, if the markets look to avoid further damage and enter a stage of stability.

Besides the obvious overall contraction in open interest among future traders positioning, which is often a theme that plays out in severe bouts of risk aversion, another key thing to watch in terms of positioning, is the US dollar.

According to recent retail FX trading data, it is quite noticeable that retail traders are yet again "late to the party," and after months of fighting (or buying) the greenback while it fell, they (retail FX traders) are now selling the USD, fighting it while it goes up.

This is why the US dollar could appreciate amid additional forced selling, since it too is quite an over-crowded trade to the short side. The other major force to watch is what is happening in the treasury complex.

It seemed that global markets were at peace with interest rates going up, that is until the long-end started blowing up just recently, forcing the yield cure to steepen quite dramatically. This re-in forced that stocks for the first time in some time not as competitive as the widely followed 10-year yield. The coming-in of that key spread differential provided the backdrop for equity markets to correct.

While, the majority of market pundits continue to point towards the importance of 3% on the US 10-year yield as the key level to watch, the fact is that both the 30-year and 10-year yields have already broken-out of long-term negative trends. Both have broken and bounced off key downward-sloping trendlines that have capped yields for years.

From a technical perspective, the long-end has gone parabolic, which suggests that if equity markets continue to build of Friday's stability, they (the 30-year and 10-year yields) are in position to complete long-term basing patterns (monthly chart double bottoms). Those levels to watch are 3.25% and 3.04% for the 30-year and 10-year respectively.

On the other hand, treasury markets are extremely oversold or in other words, yields are very overbought according to weekly RSI readings. And, at the very least, could face a head-wind, in terms of risk aversion stemming from equity market volatility. That said, the undeniable trend by futures speculators is down. In other words, both the US and TY (30-year and 10-year futures contracts) have seen the net long positions collapse as price-action has fallen too. As of Tuesday, they were still at 54% and 39% net long (30-year & 10-year respectively), far from extreme levels. Thus, in that sense, the sell-off in treasuries does indeed have room to go, which could allow for forced-selling February to frantically continue.

Where Do We Go From Here?

Equity markets confirmed the prior week's buying exhaustion by reversing hard (to the downside) last week. As a result, both the S&P 500 and Nasdaq 100 indices have marked key reversal patterns. That said, Friday's volume didn't spike by that much and felt like more of a buyers strike heading into the weekend than a panicky sell-off.

Typically, bull campaigns of this magnitude tend to finish with some sort of climactic, high volume, blow-off move. This, of course, is not what happened. Instead, as mentioned, equities left behind both a daily and weekly bull exhaustion (heading into the previous weekend) that failed to follow-through at the start of last week. Then, coupled with the fact the Dow Jones Industrial Average was over 3 standard deviations above its 200-day moving average for the first time ever, and that the S&P 500 was at historic levels of overbought conditions (weekly RSI), and you have makings of a perfect storm or in this case, a classic corrective pullback.

It should be noted, however, that similar to the start of last week, that this week the markets open with the exact same situation, starting a new week after both a daily & weekly exhaustion closed into the weekend. Except, this time, however, it comes on the heels of a strong (bearish) reversal signal. Also, strong trends tend to end counter-trend movement in a quick, exhaustive-type manner, and this correction does indeed fall into that category. That said, if there's no sign of a hesitation to start the week, or in other words, if it looks like equities are not immediately stalling-out come Monday, then it looks like markets could correct quite a bit further given the length of time it has been since we saw a 5% correction.

In these situations, markets tend to overshoot because there's often an emotional component associated with sell-offs, but this type of sentiment has clearly not happened thus far. In fact, on Friday, market participant after another (on TV) echoed their complacency, reiterating the fact that this was a well-needed pullback. This sense of resolve can work both ways, however, which again points to the importance to this week's opening price-action.

So, where do markets go if indeed there's a continuation to last week's (bearish) outside reversal pattern? The most logical answer is where the last drive that re-accelerated the uptrend begun, which occurred at the very start of the new year. A corrective (down) move of this variety would also correlate with a decline back down below 25,000 for the DJIA and roughly 2665 & 6400 for S&P 500 and Nasdaq 100 futures respectively.

This would also fit nicely with Gann retracement theory, which suggests that full-fledged reversals retrace 50% of the original move and corrective pullbacks typically retrace one-quarter of the original move. A 25% retracement of the entire move from the so-called "Trump low," which took place when Donald Trump was declared president back in early November 2016, lines-up perfectly with the aforementioned 2665 for S&P 500 futures and 6400 for Nasdaq 100 futures.