In the article, "The Dollar Index: High Risk of Unraveling", I presented a purely price based model that suggested that there is about a 33% chance of a significant downside move in the Dollar Index over the next 26 weeks. However, a reader correctly noted that investor sentiment towards the Dollar Index is very bearish, and the reader wanted to know if this figures into the analysis and why wouldn't I be bullish if everyone else is bearish. Here are my thoughts.
Figure 1 is a weekly chart of the Dollar Index (symbol: $DXY). The indicator in the lower panel looks at investor sentiment towards the Dollar, and this data comes from the MarketVane Corporation. Values below the lower trading band (like the current value) are consistent with extreme bearishness towards the Dollar. The black dots on the price bars are key pivot points. Key pivot points represent areas of buying (support) and selling (resistance).
Figure 1. $DXY/ weekly
Looking at figure 1, our reader is correct in that sentiment towards the Dollar is bearish, and yes, this should be considered a bull signal. At least, this is how it worked at points A, B, and C. Sentiment got too bearish and prices bounced higher. Now look at points 1, 2, 3, and 4. At these points, sentiment also was bearish towards the Dollar, but the reversal never really developed. So bearish sentiment -as a reason for a bounce - doesn't work all the time, and in fact, in the Dollar Index, you might be better off selling than buying at least over the past couple of years.
So this is what you need to understand about bearish extremes in investor sentiment, and this is regardless of the asset you are looking. Extremes in bearish sentiment should lead to a reversal in price, and these reversals or areas of buying become support levels. Failure of buying, when investor sentiment is extremely bearish, signifies a new trend. Failure of old support levels to hold leads to new trends.
Returning to figure 1, look at the most recent key pivot point. At this point, sentiment towards the Dollar was extremely bearish and there was buying which led to a weak counter trend rally. 76.65 is support as this was the last area of buying. Last week prices on the $DXY closed below these support levels. We should of had buying at 76.65 not only because it was support but also because sentiment is bearish. This has yet to develop, and until price closes back above 76.65 (on a weekly basis) the trend is down.
In summary, our initial price based model suggests the potential for excessive weakness ahead for the Dollar Index. A weekly close back above 76.65 would likely nullify this set up.