Reading the Tea Leaves

Investors and advisors generally fall into two camps with regard to technical market analysis: those who give it credence, and those to whom it is the basest superstition. The latter camp liken it to divining the direction of the market by reading tea leaves or animal entrails. Market technicians place enough faith in it to have developed a professional certification for the practice. Most investors fall somewhere in between the two extremes – a curiosity that, for some reason, frequently seems to work

One of the more interesting techniques is application of the Fibonacci number sequence or “Golden Ratio” to price movements (and more rarely, to time). Those curious enough can check this out at Wikipedia (for the mathematical basis), or Investopedia (for its financial application). The ratio occurs frequently in nature. Fascinating stuff unless you are a mathophobe.

Last week the S&P 500 very nearly completed a nice Fibonacci retracement of its entire move from the October 2007  high  of 1576 to the March 2009 low of 667.  The details, rounding to whole numbers, are like this:

1576 – 667 = 909 point move down.

62% of 909 = 564 points

Therefore, this would forecast a move to 667 + 564 = 1231 price level

Last week the index reached ~ 1214 before Friday’s selloff. One of the tenets of technical analysis calls for the next leg to be of roughly equal length to the initial one, in a zig-zag type of pattern:

A to B = C to D, with the interim movement B to C being a Fibonacci retracement of A to B.

Applying that principle, our next target for the S&P 500 would be:

1214 – 909 = 305 (!), which is a move to a new low for the overall sequence.

To be sure, that is an extremely dire scenario, and we will have much bigger worries than wondering whether arcane numeric ratios apply to the stock markets. Whether it plays out is anyone’s guess, but it is one possibility. Why this type of technical analysis works (when it does work) is a bit of a mystery. Could be a self fulfilling prophecy: it happens because traders are watching for it and expect it to happen. Let’s hope it’s nothing more than reading tea leaves.

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