Sunday, 4 July 2010

Stocks - Fibonacci analysis of the current breakdown

I thought we should take another look at the ongoing breakdown in stock markets, as further research throws up the intriguing prospect of a short term bounce-back - and what's likely to happen if we don't get one.

As regular readers will know, I'm currently taking my cues and clues from seven powerful historical precedents.  These examples of market behaviour in extremis, going way back to the Great Depression, show what happened after a massively strong burst of momentum from a bear market low, as we've seen over the past year.

I discovered that their subsequent behaviour was uniform in many regards.  None could sustain the historic momentum in the short term and, in five of the seven cases, the market peaked and rolled over into a serious breakdown soon after.  

Today's behaviour is, so far, following the same path.  The market has fallen quite substantially from its highs and seems to sit at a perilous crossroads.  What can we expect from here?

Using a common technical measure - Fibonacci retracement lines* - I've been able to find some simple commonalities in past precedents which might be able to help.

*Fibonacci numbers are a mathematical phenomenon occuring naturally throughout nature.  Amazingly, they occur with great frequency in stock market behaviour, going right back to the days long before most traders had even heard of such a thing.  Here's a link to an explanation of how they work.

Lets take a quick look, starting with the examples which worked out most bullishly:


Wide shot

Once the powerful move up from the 1982 low topped out, the market retraced just over 38% of that, with a pause for breath halfway through.

Close up

Having hit that textbook retracement level, it spent the next year working its way back to the highs, finally breaking out above them 18 months after the initial peak.  This breakout signalled that the economic recovery was sustainable.


Wide shot

Again, once the market topped after a momentous rally, it fell back to retrace 38.2% of the move.  With little drama it began a strong rebound back to the highs.

Close up

It's rally back to the highs - as in 1983 - was broken briefly in the middle by some sideways movement.  It needed to come back down to retest its October '33 low before taking off again.  The market broke out above its highs in May 1935, 2 years after the initial peak.  That breakout, once again, signalled a sustainable rally.

The five other precedents didn't work out so well.


Wide shot

The above measures the retracement levels between the lows of 1932 and the high of 1937.  A dip retracing around 23% led to a sharp rebound before the crash hit...

Close up

It was a strong rebound, 76% of its fall from the peak, but it didn't reach the old highs before rolling over steeply.  That was an investor's clue to get the hell out.


Wide shot

This measures the retracement levels between the lows of 1938 and the high later that year.  In terms of its technical structure this is the most similar precedent to our current market.  

Close up

Once it had fallen to retrace 38.2% of its move from the low, hitting 136, it bounced strongly and again almost reclaimed 76% of its decline from the peak.  A failure at that point again led to a major sell-off. This sliced right through all previous support and, despite a subsequent rebound into 1940, the weakness was irrepairable.


Wide shot

On this occasion, one could argue whether the Fibonacci retracement measurement should begin after the lows of 1987, 1994 or 1998.  So I included all three.  You can see how the highs and lows bounce around between these lines.  The top came in January 2000 and a first fall to the 38.2% retracement of the move up since 1998 was met by a strong rebound - 76% of the decline from the peak. It failed, however, to reach the old high.

Close up

The market was overwhelmed by bullish sentiment and continued to hold out for a year, but could not reach its January peak.  A breakdown below the lows, in March of 2001, was the final clue that the party was over for anyone who hadn't already taken the hint.


Wide shot

Now we come to the real horror crashes.  The above chart measures from the low of 1982 to the top in '87.  But that's unhelpful, so I've taken another measure from the lows of summer '86 which is more instructive.

Close up

Here you see how the market retraced 38.2% of it's move since the previous year's low, but could only bounce weakly before drooping to a 50% retracement.  The subsequent rally failed within ten days and then began the downward momentum towards Black Monday, October 19th and a 20% one-day wipeout.


Using the major 1921 low is again unhelpful here, so I've instead measured from the significant low set in March '29, up to the peak in September.  The market paused for just a day at the 38.2% retracement of that move (Dow 346) before pushing lower.  It bounced strongly only once it had erased 61.8%, and then only for a week.  The Wall St Crash followed.

Here is the current picture, July 4th 2010:


Here are the common features I see in these precedents. One has to be careful not to draw too strong a set of conclusions, but I think there are a few things we can say with a fair degree of confidence:

  • At a minimum, the current downtrend should retrace 38.2% of the move since March '09 - which means we will hit 9429 on the Dow - before a major bounce is possible.  A minor pause now is a possibility, but it should not hold.

  • Once it hits 9429, a strong rebound is likely.  If the index cannot rebound powerfully at that point, an all-out crash is very much on the cards.

  • If that rebound does materialize, it should take us up quite close to the April highs - a very tradeable move.

  • If the market then goes on to reach the April highs, without having broken back down strongly, it will have repeated the price behaviour pattern shown in the rebounds of 1933 and 1983 - suggesting a full market recovery could be on the horizon.

  • If 9429 breaks convincingly, however, the precedents are dire.  Expect a swift plunge to lower support levels at 8864, then 8299, which is the last line of defence before we tumble all the way back to the bear market lows at 6469.