Dollar Bearishness Impacts the Market

 |  Includes: DIA, QQQ, SPY, UDN, UUP
by: Babak

A few weeks ago I mentioned that the US dollar and Euro sentiment had gotten lopsided enough to warrant our contrarian oriented attention. The US dollar sentiment had reached extreme bearishness while there was full blown euphoria about the Euro.

Apparently, with the scary headlines about Greek debt receding from front pages everywhere, suddenly everyone is happy to sell the US dollar and hold Euros. Even the Chinese have bid up Greek debt, pushing the 10 year Greek sovereign debt to 9.27%, down significantly from its recent double top at 12%. The crescendo of QE2 (quantitative easing) expectations from the Federal Reserve haven’t helped the dollar either.

The most recent Daily Sentiment Index (NYSEARCA:DSI) reading for the dollar shows an even more extreme bearishness: only 3% of retail traders polled believe that the US dollar will appreciate. This is the level that we saw when the US dollar bottomed out in late 2009: “Anything But Euros” Pushes Dollar Sentiment To Extreme. But less bearishness than it took for the greenback to rally in early 2008 (6%).

US dollar SPX comparison Oct 2010Click to enlarge

There are also other clear indications that this move down is over-played. The RSI for the US dollar for instance hit an extremely low of 22 recently. That is the lowest level since March 2008. As well, the US dollar’s relative distance from its long term moving average is back to where we last saw it in late 2009 and early 2008 - instances where it rallied strongly. So it is clear that sustaining such a pace of decline is highly improbable since it corresponds to a severe level of gloom and of being technically oversold. I don’t know exactly when but a dollar rally is expected to take place soon. And when it does, we shouldn’t miss the higher lows that the dollar would carve out on the chart.

But more interesting than that is the relationship of the dollar with the wider US stock market. As you can see from the chart below, the US dollar and the S&P 500 index have been opposite each other for some time. The correlation isn’t a perfect -1 but even a cursory perusal will reveal that when the US dollar is rallying, the stock market usually goes down (or at best sideways).

Hedge Fund Sentiment
So we can add the potential for an intermediate US dollar low to the list of cautionary signs for a weaker stock market. As well, the hedge funds who are considered the ’smart money’ have been reluctant to jump on the rally bandwagon. According to the latest TrimTabs BarclayHedge survey conducted in early October, only 31% were bullish on the S&P 500 index. Slightly more (37%) were bullish on any other stocks.

While most would feel comfortable calling hedge funds ’smart money’, as we saw in the asset correlation grid, they haven’t really been able to offer their clients much of a safe haven. Nevertheless, I’m reluctant to interpret their lack of enthusiasm as being a contrarian indicator. Especially when there is ample evidence from other sources suggesting a weaker equity market ahead.

Election Year Cycle
The only positive note - and it is a significant one - is that we are smack dab in the middle of the most intense period within the presidential cycle. Also known as the election cycle. According to Ned Davis Research, since 1900 (till 2009) the Dow Jones Industrial has returned 3.7% in the second year of the presidential term (current year). Next year, as the third year has on average returned a whopping 12.6% and the last year 7.5%.