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Stockmarket example

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Fibonacci Numbers

November 1, 2009 sageinvestor 4 comments

Study the graph below carefully (I suggest right-clicking the image and then open it in a

new window, zooming in a bit). Notice the lines drawn. Each line has a percentage

associated with it, like 38.2% or 50%. These lines measure the percentage rertracement

of the distance from the March 2009 bottom relative to the October 2007 peak. Time

after time, corrective or countertrend rallies do not end at indiscriminate points, but at

spectacular ratios that are found everywhere in nature. Sounds weird? Well, these ratios

are far from the fringe; they have fascinated the greatest of minds including Plato,

Pythagoras, Bernoulli, Kepler, Da Vinci and Newton. Even the great architects of

ancient Egypt took notice, enshrining these ratios in the scale of the Great Pyramids.

Wait a minute! Aren’t we supposed to be talking about stock price measures when we

talk about the stock market? Not entirely. I believe one should first address something

more fundamental, the interaction of people en masse, or their natural forces at work. To

do that fully though, I have to tell you more about these ratios.

In 1202, a mathematician named Leonardo Fibonacci da Pisa published his famous book,

Liber Abaci (The Book of Abacus, or The Book of Calculation), which introduced many

great mathematical discoveries. Most notably, Liber Abaci was celebrated in its day for

introducing Europe to the decimal system with zero as the first digit. [1] But buried in

Chapter 12 of this 500-page book is a math problem that made the author’s name famous,

for it explains an infinite array of numbers known as the Fibonacci sequence. My goal is

to talk about Fibonacci numbers as they relate to the real world. But in order to get to

where I want to go I have to tell you more about this remarkable sequence.

Fibonacci numbers are created by starting with the number 1. From that point, the

sequence is developed by simply adding the last number in the sequence to the current

number, creating the next number in the sequence. Starting with 1 and 0 (or nothing

before it), we get 1. Then adding 1 and 1 we get two. 1 plus 2 equals 3, 2 plus 3 equals

5, 3 plus 5 equals 8, etc. So the beginning of the Fibonacci sequence looks like this:

1,1,2,3,5,8,13,21,34,55,89…

Looks pretty innocuous, right? But wait til you see where it goes…

There are other number sequences, but this one is unique, it’s special, and it alone is the

reason Fibonacci is famous. After the first several numbers in the sequence, the ratio of

any number relative to the number directly to its right is approximately 0.618 and the

ratio of any number relative to the number directly to its left is approximately 1.618, the

reciprocal of 0.618. As the sequence expands, this ratio converges exactly on phi, or _, an

irrational number equaling 1.6180339887… Phi is the only number that when added to 1

equals its inverse: 1+0.618 =1/0.618. Between alternate numbers in the sequence the ratio

is 0.382. 1 minus 0.382 equals 0.618. The mathematical phenomenon of the Fibonacci

sequence continues [2]. For now all we need to know are the Fibonacci numbers

themselves and phi, which is also known as the Golden Ratio or Golden Mean.

Phi is all around us, and it is within us. It is the basis for the construction of Golden

Rectangle [3]. It is found in the proportions of man and in nature. Look at these images

below [4]:

Examples of Fibonacci numbers in nature: Proportions of a human being, bones in the

finger, DNA double-helix segment

The Golden Rectangle is remarkable for another reason. If you divide the Golden

Rectangle into smaller Golden Rectangles repeatedly you get the backbone for the

development of a spiral, which emanates out of the Golden Rectangle. This is known as

the Golden Spiral and it is depicted in Figure 1. [3]

Figure 1

There are some amazing properties to the Golden Spiral too [5]. The Golden Spiral is

abundantly depicted in nature, as the images below show.

Now if you got this far you must be wondering how this equates to stock prices and the

like. Some theorize that stock prices are a random walk. Others, including me, believe

stock prices reflect patterned behavior. For me, Fibonacci ratios play a part in seeing

that behavior at work (but not solely). The stock market is a creation of man, and man is

natural. It is possible that the laws that shape natural things is inherent in the actions of

our collective organization, like group behavior and social mood. The stock market is the

best place to measure such behavior, because it produces an intricate and long series of

data. If there is a general law of ordered growth in the universe, than society’s broadest

and most universal measure of growth, the stock market, should be subject to that law. If

nothing else, there are way too many coincidences to simply dismiss this idea. There are

principles everywhere, even if we are unaware of them or too blind to see a connection.

One of those principles may be as simple as ‘man, being a part of nature, obeys the laws

of nature’. This is far from a radical idea: Einstein explains this best when he said, “God

does not play dice with the universe”.

________________________________________________________________________

_________________________________________________________________

So now I get back to the very first graph. Society progresses in an ebb and flow

manner. Obvious examples of this are the Dark Ages followed by the Renaissance, or

wartime followed by prosperity. The stock market is a reflection of this ebb and flow.

We find natural resting places after periods of growth, and we also find natural resting

places for periods of decline. These places often settle on Fibonacci ratios!

Notice from the bottom in March 2009 the market grew at a rapid rate, to the beginning

of May, and then settled back to a line of support (line 1), a Fibonacci ratio of 23.6%. It

rose and then came back to settle on that very same line. The summer rally saw the

market vault further, to line 2, a Fibonacci ratio of 38.2%. After bouncing around this

settling spot for a month, investors pushed prices higher. In fact, they pushed prices

almost to 50%, to line 3, another Fibonacci ratio. Can we push to the next Fibonacci ratio

of 61.8%? Sure. But I don’t think so. Like any argument you need supporting data, and

we have plenty to support this claim using this technically beautiful graph.

Overlaid on this graph of prices are a few ratios plotted of all NYSE advancing stocks to

declining stocks. You may quickly notice that they displayed a Fibonacci relationship

throughout the rally, albeit in a diminishing manner. From the bottom, the biggest bull

market days (depicted by long bars up, in green) saw advancing stocks outnumber

declining stocks by a 13:1 ratio, and then an 8:1 ratio, 5:1 ratio, 3:10 ratio, and finally a

1:1 ratio at the top. Not only is this indicative of a natural rhythm in the market, it is also

a factual depiction of a tiring market. Higher index prices are being met with less broad

market participation.

Markets also establish trends, depicted by trendlines. Trends push forward and trends

break down. No different than fads or political forces. In the stock market though, we

can literally see and measure trends, because we have the data to plot movement. When

we correctly see that movement break down, i.e., prices falling below the proper

trendline, we can literally see the change happening in real time. Last week, such a move

occurred, and it is depicted in the graph above. Prices fell below the lower purple line,

indicating a change in direction. Maybe more importantly, the market constrained itself

by establishing a top trendline to it’s growth trend, as it pushed near the upper purple line

eight times. The market’s decision to fall away from this trendline tells us the same

thing, the trend is changing. Put them together and the argument is strengthened

considerably.

Finally, there is a white line drawn at the top. It connects the all-time top of 1576.03 in

the SP500 on 10/11/07 (not shown) and the near term top of 1101.72 on 10/21/09. Notice

the confluence of this trendline with the top purple trendline. They met, and the market

turned. Coincidence, or natural next move? If you believe in the Efficient Market

Hypothesis or Keynesian economics you can easily dismiss this theory for those theories.

I prefer behavioral economics, as I believe investors act irrationally and that investors are

prone to herding behavior (see previous posts). That supports trending, and that supports

a natural rhythm in society and in its stock market.

[1] Fibonacci learned the Hindu-Arabic system from the Arabs while living in

North Africa. More accurately, the Arabs rediscovered it. The Babylonians

developed digital values and were the first to use the value of zero. Separately,

the Mayans also developed a digital system without zero many years later.

[2] To name just two more: The sum of all Fibonacci numbers in the sequence up to any

point, plus 1, equals the Fibonacci number two steps ahead of the last one added. The

square of a Fibonacci number minus the square of the second number below it in the

sequence is always a Fibonacci number.

[3] An explanation of the construction of the Golden Rectangle and the Golden Spiral can

be found by clicking here.

[4] For more on the Golden Ratio, the Golden Rectangle, Golden Spiral, and the Golden

Segment click here.

Golden Mean, Golden Ratio, Golden Spiral, herd behavior, Phi, social mood

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