December 7, 1999

European currencies rallied swiftly on Monday, December 6th after German manufacturing orders showed a stronger than expected gain for October. But in a world overburdened with economic numbers that all-too-often show conflicting evidence of economic growth or stagnation, the real culprit for the magnitude of that move must also find its beginnings in the excessive bearish sentiment on European currencies last week.

You see, as of Wednesday, Nov 30th, almost no one expected that either the euro or its neighboring Swiss franc were capable of strengthening.

At least that was the view of U.S. market newsletter writers surveyed by Market Vane, a Pasadena California-based research firm. That organization regularly surveys over 100-U.S. market newsletters, deriving a percent bullish calculation on a variety of futures markets. The November 30, 1999 calculation showed just 3% of market newsletters advocated a long Swiss position. Only 7% of the same newsletters were bullish deutsche mark futures. In the past when sentiment on a given futures contract has reached such an extreme, it has often been a warning sign that the market in question is ripe for a countertrend rally. U.S. dollar bulls late to the party learned this on Monday morning.

Within an overall dollar up trend in 1999, the Swiss franc sentiment level was as extreme as this on just three prior occasions. The sentiment calculation -- officially referred to by Market Vane as the "Bullish Consensus" -- first stood at no higher than 5% bullish the franc for the period between April 19, 1999 and May 3, 1999. Sentiment also touched just 3% bullish between July 9-13, 1999, and 5% bullish once again on September 10, 1999.

In all three instances, sharp rallies in the Swiss franc followed immediately thereafter, although the duration of the rallies varied. On the first occasion, the rally measured 2.4% and lasted only a few days; on the second occasion, the rally measured 6.1% and lasted almost a month; and on the third occasion, the rally measured 6.3% and lasted the better part of six weeks. These previous three moves taken together marked the only major periods of Swiss franc strength within a year where both the euro and the franc have slowly been trending lower. The euro followed a similar path as the Swiss franc during these times.

The Bullish Consensus is a contrarian-trading tool popularized by Earl Hadady in the late 1970's. The specific calculation is done on a weighted-average basis using the number of subscribers that receive each market letter. Readings above 85% bullish are a warning sign of an overbought market, while readings below 15% are a warning sign that the market is becoming oversold. Although Mr. Hadady is no longer involved in the day-to-day Market Vane calculations, he is currently finishing a second version of his early popular text "Contrarian Investing."

Rich Ishida, another member of the Market Vane team, said last week that the Bullish Consensus is not a tool that he would want to use in isolation without regard to other fundamental and technical factors. He anticipated however that the recent extreme readings in both the Swiss franc and the Deutsche mark "should cause at least a short term reversal in the dollar bull trend, even if the longer term trend on the dollar may still be up." We expect Mr. Ishida was smiling a bit at Monday's price action.

Not Always a Perfect Tool

One should note that the Bullish Consensus has not always been as prescient a tool as it has in the 1999 Swiss franc market. When sentiment extremes of this magnitude have appeared in earlier years, they have tended to come in the latter stages of a move, but have not always served to pinpoint an exact moment of reversal.

The fact that the calculation only measures the sentiment of U.S. market letter writers on an asset that trades globally is also bothersome to some in the cash market. Empirical evidence suggests that the sentiment calculation may be a less valuable tool in foreign exchange markets than it is in other futures and commodity markets that are traded only in the U.S.

Intermediate Term Traders Not Yet Out

Nonetheless, for the fourth time this year, the ultra-low readings that we experienced last week successfully served as an early warning sign of an overdone market situation. All it took was for one piece of strong European economic news to send many trend followers scurrying out of their long dollar positions.

At this juncture, most short term traders long the U.S. dollar against the euro and the Swiss franc have already run for the exits. The intermediate traders most likely have not. A few more days of European currency strength will be required before many computer-guided models will flip.

Market Vane's sentiment numbers are still extremely low in the European majors as of Monday's close (the Swiss Consensus now stands at 8% and the Deutsche mark at 12%) while on the other end of the spectrum, the market remains 85% bullish the yen (down just slightly from Friday's 89% reading).

Whether Monday's European currency rally peters out in a few more days or becomes a larger affair, the sentiment indicators certainly indicate that Swiss franc-yen and euro-yen crosses both have room to rally further. One might consider buying a swiss-yen pullback with a stop-loss set below 64.70, or buying the euro-yen with a stop-loss set below 103.20. If we haven't seen the bottom in these crosses, we should be getting pretty damn close.

Further information on the Bullish Consensus and Market Vane services can be found on their website, MarketVane.Net