Italian mathematicians and the stock market

Before we get started – if you missed my BNN show on the last trading day of the year–you might want to view it here.

On the show I gave a couple of reasons why there is a decent chance of a pullback into the late part of January–despite my views of a relatively bullish market going into the spring

While we are on the topic of making predictions – I do occasional speaking engagements on the subject of technical analysis (imagine that!). Inevitably, somebody in the audience asks me for my opinion on Fibonacci retracements and targets. If you are a believer in the magic of Fib numbers, you might be offended by my views on the subject. After all, some view the subject of the Fibonacci numbers, which is often tied into Elliott Wave Theory – to be almost religious in nature. I’d encourage you to Google both of these terms to find a bit about them if you aren’t familiar – as I won’t go into the details of their usage in TA here. This blog will make more sense to those who do have a base understanding of how Fib retracements are used.

I consider myself a fairly logical person. As such, I try my best (not always succeeding) to avoid conceptual views of the investment world as much as I can. Despite it all, I am sure Star Trek’s Mr. Spock wouldn’t approve of much of my activities!

The logic behind Technical Analysis appealed to me very early in my career. TA acknowledges that markets move based on human emotions (fear, greed), traders memory (where we bought a stock, where we sold, where we missed buying or selling) and supply/demand.

Applying a series of numbers that happen to have a mathematical relationship to measure potential support or resistance targets for a security makes no sense when considered from the positions mentioned above (i.e. supply/demand, fear/greed, etc). Yet, “believers” will be happy to show you the magical support (or resistance) levels that met a stock or commodity when it hit a particular Fibbonaci target. On the DJIA chart below, I took the January 2016 low price point and the first consolidation high since that date- which happened in August. From there, I used the stockcharts.com Fib retracement tool to predict retracements. In fooling around with the tool, I then tried other time periods with random lows, and random highs. And, as expected – I got random results (some  of the calculated “support” areas worked, some didn’t). One observation I note is that “believers” like to prove that Fib numbers work when– in hindsight – they know where the actual high occurred.

Any indicator will show success some of the time- no matter how illogical. For example, the market might go up every time my lovely assistant Cindy wears a white blouse. And it might fall if she wears a dark blouse.  I’d suggest that any indicator based on illusionary market predictability (like Cindy’s blouse colour) provides little value for future predictions. Elliott Wave and Fib watchers in particular have an unhealthy does of confirmation bias in their analysis. Confirmation bias is the tendency to search for  evidence that supports one’s belief. I can search for examples of the times that Cindy’s blouse predicted the market direction – I can use the data sample to prove my point. For example, perhaps her colour choice worked best over the last 100 days, but hasn’t had such a great track record over the prior 100 days. Now that I have data-mined to prove my point, I can start a newsletter!  Given the number of potential retracements when viewing Fibonacci divisions , it’s quite easy to find examples where a stock or security has retraced and bounced off of a Fib number.

Like the blouse colour – just because a stock bounced off of a Fib projection point, doesn’t validate that particular percentage retracement as something that should be used for trading targets in the future. Cindy’s blouse’s seemed to have an ability to predict stock market behaviour. So too can stocks can randomly bounce off of a Fib price point. Just because the same number occurs in spirals and rabbit birth predictability (again- Google Fibonacci and you will find out about these uses for Fib mathematics) doesn’t mean its applicable to a stock market that is driven by supply and demand. A bounce off of a 61.8% retracement wasn’t because of the fibonacci level-  It was because of human behaviour forcing changing points in supply and demand.

Should you still insist on using Fib numbers to trade off of, you may also wish to subscribe to my upcoming investment publication. This wonderful newsletter will detail my never before revealed market timing techniques revolving around Cindy’s blouse colour choice. Subscriptions are expected to cost six figures per year – no money back guarantee if the system fails to work, of course. Each subscription comes with a free bottle of Snake Oil.