Is stock index rally running out of steam? Some thoughts on Fibonacci

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So far all predictions for the demise of this powerful stock market rally have been wrong. Certainly we’ll hear of all the successful forecasts after the fact, as we always do. It’s a little more difficult to call a top in real time. Every time the market looks like it is going to finally pull back, another wave of buying comes in. This can’t last forever, but it can be treacherous betting on which one of these little pullbacks will gain momentum and create a meaningful impulse move down. What is even more frustratiin is that this uptrend seems to be contrary to every logical conclusion that can be derived from the fundamental backdrop. I attempted possible explanations in the previous few posts on this blog. There will be a point when this market turns south. There is evidence that such a point could be at hand now. But there have been many previous points that looked compelling for a downturn, and yet the buyers kept coming in. I have no idea if the downturn will come now or at a point from much higher levels. I won’t even attempt a guess at this point. But it is always a good idea to put the daily price moves into context by looking at the bigger picture.

Here’s a longer term view of the etf of the S&P 500. In a previous post I had a weekly chart showing the same Fibonacci retracement levels. The chart above is a monthly chart giving a little better picture of the large, smooth uptrend preceding the much faster and urgent retracement. It is interesting to see how long and steady the bull market was from the 2002 and 2003 lows to the highs in 2007, and how quickly the entire move was retraced. Also, there has been an urgent and steep climb back up almost exactly half way. I also have a green line on this chart that is a strong area of support. You can see several rejection lows back in the 2002 to 2003 period, as well as one large rejection tail in March of this year that launched the current rally. Most traders draw the line on the lows of those bars, but by viewing these bars as candlesticks and drawing the the line on the body of the candle it is much easier to think of those spikes down as areas of price rejection, especially on the monthly chart. Any resumption of the downtrend will likely find many chartists expecting support again at those levels. Being a contrarian by nature, I would disagree.

It seems most traders are capitulating to the bull move and jumping on the bullish bandwagon. First, I view the steepness of the previous downside as ominous since it retraced the entire previous impulse move up. It took back almost five years of upmove in about 17 months. It is common for downdrafts to be much steeper and faster than upmoves, but this move erased all of the gain which puts into question a bull market from a longer term perspective. And now the retracement back up is just as steep and urgent and the previous downmove. It just feels like there will need to be some retesting of the downside at some point. The trend is still down. The fundamental backdrop has many pitfalls. The fast move back up seems more like a retracement of the previous downtrend that it does a new bull market. The views of this market on the daily and weekly charts appear more bullish, but the monthly chart is less convincing, at least to me.

It seems a bit too convenient that price has move just up to the 50% retracement level, and the double stochastic in the lower sub-graph is starting to roll over from a very overbought area. This indicator can sometimes just indicate a slowing of momentum rather than a reversal. There is no pattern of divergence on this chart to indicate a more serious reversal pattern. But it is just an indicator. It doesn’t predict prices will fall just because it is in the overbought zone. But with the trend indicator (blue lines) still down, the price patter still down, and the indicator overbought, it is something to keep an eye on to at least temper some of the bullish enthusiasm.

A word about the Fibonacci retracement level. I use a tool in TradeStation that can snap to the high and low of an impulse move, and then calculate various levels within that range, or even calculate extensions beyond the range. The basic Fib retracements are .382 and .618. The middle line is the .50, or 50% level. In other words, half way back up from the distance of the previous drop, in this case. I know many trader put much emphasis on Fibonacci retracements and extensions. I studied this approach many years ago, and I found it to be completely useless. I’ve seen all the charts with perfect retracements or extensions right to the tick of some Fib number. Of course all the examples you will find will be in hindsight. It is much like Elliot Wave. If a pattern or Fib number doesn’t fit, there are many alternates available to fit the past prices to show a perfect fit. It is a little more difficult to do in real time, if not impossible. Traders will often try to find clusters of Fib numbers with starting and ending points at various swing points. Traders will also add many more permutations of Fib numbers to create in between points with the result a chart of so many lines that one of them will be bound to be hit and turn the market around. But if it does it is just a coincidence. I have drawn lines randomly on a chart with my eyes closed, and sure enough one of them will be bound turn the market around. I think such study of the market is a waste of time for the trader, but there are many services that profit from offering advice and eduction using such methods. I could be wrong, but based on much study in that area it is a conclusion I’ve come to from experience. With that being said, I do find the 50% retracement area interesting, and do at least keep it in the back of my mind when analyzing price swings. I don’t think there is any magic to a 50% retracement other than the fact that so many traders look at that area as a target to end the correction of a previous impulse. I think it simply becomes self-fulfilling. Nothing more. But there are many instances on a chart when you will see a 50% retracement of a previous impulse. But in real time it is not always clear which swing points to use in calculating exactly where the previous swing starts and stops.

So that was a word on Fibs. Now a word regarding those price rejections under that green line. Technicians do use previous swing points, or pivot points, to use as a guide to see how a markets will test those levels. On a short term basis this makes sense. The market will move up to a point and then pull back. Then it will move up again and test the price area where rejection occured and previously stopped the market from moving higher. On this test the market will either reject that price again or if enough buying accepts that price, then price can move higher to find another level that again attracts selling and stops the upmove. This process happens in all time frames in both up and down markets. The swings that seem random actually have meaning and purpose. However, how far back will those swing or pivot points still have meaning? Regarding the current market, the March 2009 low will probably have significance if it were to be tested in the near future. If those lows are approached or equaled, and prices were to reject that area and move higher, then the market would look healthy. If those lows are accepted and trading continues at those levels, prices will likely move lower. But how relevant are those lows back in 2002 and 2003. It does appear on this chart that those price levels were where the market decided to stop going down. It may have been a coincidence, or may be that enough traders decided to step in at those lows as they perceived value where prices got rejected in the past, however far back that may have been. It seems that prices on an index that far back should not be relevant today. There is much re-balancing of the stocks in the index. There are inflation and currency adjustments, as well as dividend and interest rate considerations. The further back you go it seems there should be little influence on the current market, other than psychologically or by being self-fulfilling. But then again, what should makes sense logically doesn’t always have to in the markets.

My next post will be the first week of November. I’m taking a much needed rest from the market next week.