How to Spot Sentiment-Driven Price Moves

The last few years have shown investors just how important market sentiment can be in determining price movements. Now, with the end of 2010’s trading within sight, I wanted to clue you in on another way to gauge sentiment going forward. With this strategy added to your technical tool box, you’ll have a better chance at spotting significant sentiment shifts – and at making profits in this market…

As you know by now, I am a “sentiment” analyst and trader. I focus on carefully quantifying bullish versus bearish sentiment in the currency markets. But how, exactly, is sentiment measured? That’s a key question. There are a lot of ways.

Among the most popular is the concept of a trend — the general direction in which something moves. An uptrend indicates a bullish dominant sentiment and a downtrend the opposite. I think, though, there are better ways to understand and map sentiment. In fact, I believe there is an excellent tool to track sentiment and quantify it.

I have written about it in my book, Sentiment Indicators (Bloomberg Press), and introduced it to you a few weeks back. Today I want to go a bit deeper as I use this method to show you my latest findings on the U.S. Dollar Index.

Look at the chart below showing the U.S. Dollar Index movements each day:

If you’re familiar with technical charts at all, you’ll recognize that it’s not a candlestick chart. It is called a price break chart. It shows consecutive daily new high closes (white) and consecutive daily new low closes (black).

If the U.S. Dollar Index doesn’t move enough to create a new high or a new low, no new bar is added. If the price moves enough to take out the previous three high closes, sentiment is considered reversed and we add a black bar. If the price moves enough to take out the previous three low closes, we switch back to using white bars.

This kind of chart really shows the ability of bullish or bearish sentiment to persist over time. And looking at the chart, we see very strong bearish dollar sentiment since June. It led to 18 consecutive new daily low closes.

We also see that right now the index is in a slightly bullish reversal, with three new high closes. In short, the U.S. dollar bears have had a challenge lately and couldn’t persist enough to keep a streak going. So the market sentiment on the U.S. dollar has shifted.

Keep in mind, this is not a prediction of future direction. It is a description of current facts. It is also important to quantify the size of the move. We can see that the white bars are not large. They are medium-sized, and a clue to future direction will be whether they get larger, showing stronger sentiment, or compress, showing signs of weakness. An interesting fact is that over the past two years, bearish sentiment sequences are longer and stronger than bullish ones. When there have been bullish shifts on the U.S. Dollar Index, they did not achieve consecutive new highs more than 11 days in a row. Put differently, bearish sequences have outperformed the bulls.

The tactical implications are very important and lead to support of a contrarian understanding of market moves. When the U.S. Dollar Index is in an extended period of either lows or highs, expect it to be punctuated by reversals. When the market shows choppy periods, it indicates a period of indecisiveness. This is the current environment, where there is a vast uncertainty about the Fed’s ability to restart economic growth. Choppy markets feed on themselves as they digest any bit of information to re-energize bullish or bearish sentiment.

Ultimately, the key driver is surprise. You can bet that the most likely outcome during any week is the unexpected, leading to price movements through less probable barriers… making every week an exciting ride!

I hope this little analysis whets your appetite for more sentiment indicators. The more you understand the forces that moves markets, the better you’ll get at playing them.

Regards,
Abe Cofnas
Penny Sleuth

November 30, 2010

How to Spot Sentiment-Driven Price Moves was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

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