Getting smarter through following trader sentiment (Commitment of Traders)

Everyone wants to obtain a timing advantage with market risk, yet timing is not easy. Timing decisions could be divided into three types, fundamental, price-based, or some measure of investor sentiment information. The problem with fundamental information is that data are often old so there may not be a close link with the information and the models used to find the link are often unstable. Price-based (momentum) systems work in the long-run but can have mixed performance over short-term periods. Sentiment is a diverse area of study but can provide some revealed preference of behavior.

A recent study (see "Want Smart Beta? Follow the Smart Money: Market and Factor Timing Using Relative Sentiment" by Raymond Micaletti) using the commitment of traders information seem to have promise for helping with macro timing decisions. The weekly commitment of traders report from the CFTC report provides data on aggregate position from commercial and non-commercial traders. It also provides details on money manager and dealer positions. 

Commercial trader (hedgers) positions, especially at extremes has been viewed as an important source of information. However, the value of this information for predictions has been mixed. This new research suggests that looking at the commitment of trade information across assets will have value with asset allocation decisions. Simple put, the aggregated information on trader positions in equities, bonds, and the yield curve provides useful market direction information. The combined information may eliminate some of the noise that is associated with information on the futures position in any one asset class.

In the Micaletti study, smart money indicators were developed for stock index futures, bond futures, and yield curve (bond minus note futures). These can be aggregated under the assumption that forecasts for an equity gain will be associated with net long exposure in equities, net short in bonds, and curve flattening. The smart money indicators from the commitment of traders report uses z-scored commercial positions versus the non-reporting positions scaled by open interest versus a median value for different look-back periods. The aggregate smart money indicator tells us where the market should be headed versus some measure of normality. These position indicators are put through a battery of tests to determining forecasting skill. This battery of forecasting tests come sup with the answer that using this information generates forecasting skill.

The indicators also suggest that looking at these smart money indicators add more value than momentum indicators. Additionally, it is found that the smart money indicators can help with timing smart beta risk premia. The smart money indicators can also be used as an effective tactical asset allocation tool.

These sentiment indicators can be updated every week. Looking at a variation of the smart money indicators suggest that a defensive position is more warranted based on negative net positioning in SPX, Treasury bonds, and the difference between (10-year and bond futures).