Tuesday, January 1, 2013

The Fibonacci conundrum

Bloomberg Markets published an intriguing article on the career of master market technician Thomas DeMark, founder and president of Market Studies.  Mr. DeMark is also the author of numerous books and articles on technical analysis, including The New Science of Technical Analysis.

According to the article, DeMark “believes that markets are governed by waves that crest and fall based on a series of numbers called the Fibonacci sequence and the closely related golden mean, or golden ratio.”  Fibonacci numbers appear in the following infinite sequence: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34… where each number is the sum of the previous two.  Divide on Fibonacci number by its predecessor and the quotients will cluster around 1.618 – the so-called “golden mean” or “divine proportion.”   Fibonacci ratios are of course well known and widely utilized by today’s practitioners of technical market analysis.

Not everyone is inclined to the practical application and validity of Fibonacci theory, however.  The article quoted one Matthew Beddall, chief investment officer at Winton Capital Management, as saying: “Comparing technical indicators to what we do is like comparing bush medicine to the research performed by drug companies.”  George Markowsky, a computer science professor at the University of Maine, was elsewhere quoted as saying: “There’s a golden-ratio mania, and most of it isn't based in fact.  It’s amazing to me that adults take this stuff seriously.” 

Are the detractors right?  Is Fibonacci bunk?  Or are the proponents correct in asserting that it can be harnessed to yield clues as to future stock price movements? 

My take is that Fibonacci numbers and ratios can indeed be used profitably, and with consistency, in stock trading, and there are many traders and investors who do it successfully.  After studying Fibonacci theory in the early days of my study of technical analysis back in the ‘90s I came to the conclusion that it, as with any other form of market analysis, is only workable with a basic set of rules.  You see, almost any theory of technical analysis can “work” if it’s followed in an unemotional, disciplined fashion with distinctive rules for entering and exiting individual trades.  But as with almost any type of market analysis, much of it has to do with good money management principles.  I believe Fibonacci is incidental to the success of the traders who use it; it's not the underlying cause of it.

The Fibonacci numbers and ratios mentioned in the Bloomberg article can’t “predict” the stock market, per se.  But since so many market-moving hedge fund and institutional traders use them it becomes a kind of self-fulfilling prophecy.  In other words, if Wall Street traders are all buying at the same time when the market hits a certain "Fibonacci level," it's bound to produce a measurable move in the market which can be captured by dexterous traders.

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