Contrarian Trading with Sentiment Data
In our last publicly posted research note we made the case for a sharp rally in crude oil off the $40 lows on the grounds that it was oversold relative to the price of gold and that traders were overly bearish. We were fortunate enough to have that forecast featured in Barron's this week. Today's setback in crude is likely just part of the basing process that is needed after such a sharp decline from $55. For this week's research focus we would like to bring your attention to the dollar. Specifically we want to show why we use sentiment data to forecast market inflection points.
Nearly all market turns show divergences between price and technical indicators such as momentum. Therefore we approach the study of sentiment data with the same frame of mind, anticipating divergences to appear just before a major turn sets in.
In the chart below is a two-year graph of the dollar index and its corresponding sentiment data compiled by Market Vane. Each week we show this chart to our subscribers. Note that we have also devised our own dollar index by taking an equal weighted average of the currencies that make up the dollar basket. We do this to eliminate any rogue outliers that may appear.
Here both long-term and intermediate divergences are present. Notice that each new dollar low for the past two years has not seen a similar decline in sentiment. Instead, traders have become less bearish as the dollar declined.
The second important divergence is that each bear market rally in the dollar saw a low in sentiment on average five weeks before the actual price low. Recall that dollar bearishness reached a low ebb in all surveys we follow four weeks ago. That means we may see one final spike down in the dollar next week before a major reversal.
Considering that the technical pattern is shaping up as a consolidating triangle it would make perfect sense to see a breakdown next week targeting key support at the 80 level followed by a bear market rally back to key resistance at 92.
Also worth noting is the strong spike in dollar bullishness last week that resulted from a small reversal in the downtrend. It is our contention that traders know that downside momentum is waning and are looking to position long the dollar once the trend reverses.
Bifurcation is a hallmark of all market turning points. Turning to two individual dollar pairs we see another series of divergences. Recall that we said USD/CAD would be the first to turn up, offering a brief window into the dollar's direction. This was the case back in January when sentiment reached a low and the USD/CAD bottomed before the turn in the other dollar major pairs. Since sentiment bottomed again right with what appears to be a major low in USD/CAD we are treating this as a major reversal.
Since bottoming last month the pattern is a clear "five wave" up, signifying a reversal in trend. Meanwhile, USD/CHF has not participated and instead appears to be in a sideways consolidation pattern hinting that the next move will be lower.
Interestingly, since USD/CAD appears to be in the fifth wave up, an ABC reversal should take place next week. If this coincides with a decline in USD/CHF below 1.1380 we will then look to position long USD/CAD on a 50% retracement and long USD/CHF around 1.11 as well.
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