Inside Investment: Voodoo analysis

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By:
Andrew Capon
Published on:

The wilder shores of technical analysis never want for proponents and followers. So are there perhaps truths to be found in all this numerology? Or is it just a load of bloody offal?

At the start of Dan Brown’s The Da Vinci Code, a museum curator, Jacques Saunire, lies dead in the Louvre, Paris. His corpse is spread-eagled like Leonardo DaVinci’s Vitruvian Man and in Saunire’s own blood there is scrawled a pentacle and a Fibonacci sequence. It turns out the Fibonacci sequence, a series of numbers formed by adding the sum of the previous two numbers (1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, etc) is key to finding the hidden meaning in DaVinci’s paintings and cracking the code.

Brown is by no means the first person to instill the Fibonacci sequence with quasi-mystical significance. A number divided by its predecessor in the sequence always approximates to 1.618, or phi. The golden ratio, as it is known, recurs in nature, in architecture and, of course, in art. In finance, Fibonacci numbers and the waves they create are at the heart of many technical analysis systems.

Among the lunatic fringe of technical analysis, advances and falls of 61.8% from previous highs and lows in markets – from soy beans to currencies – mark turning points. This is, of course, pure nonsense. In a recent study, Magic Numbers in the Dow, professors Roy Batchelor and Richard Raymer of the Cass Business School in London conclusively debunk the notion that the Fibonacci sequence or the golden ratio has any predictive value. The study concludes that “the Fibonacci rule is just an illusion”.

Certainly believers in the Elliott Wave theory have had a hard time of it of late. In 1938, Ralph Nelson Elliott, a US accountant, made the grandiose claim that “practically all developments which result from our social-economic processes follow a law that causes them to repeat themselves in similar and constantly recurring serials of waves or impulses of definite number and pattern... The stock market illustrates the wave impulse common to social-economic activity... It has its law, just as is true of other things throughout the universe.”

The Elliott Wave theory suggests that markets develop in three bursts with two corrections against what unfolds as a wider trend. There are of course waves within waves within waves. And, inevitably, Fibonacci’s magic numbers are used to predict the duration of waves, wavelets and super-cycles. Suffice it to say that Elliott died in 1948 having not made billions on the stock market.

Elliott’s best known disciple, Robert Prechter of Elliott Wave International, told Barron’s in 1992: “After being in US stocks into early 1987, I have been in Treasury bills ever since.” He remains an über bear, poor soul – 19 years is a long time to be both gloomy and wrong. In 2002 Prechter wrote a book predicting a stock market crash and deflationary depression. With the bear market in full swing and Japan experiencing a deflationary spiral, this view did not seem outlandish.

Since 2002 emerging equity markets are up by more than 200%. From the bottom in March 2003, the MSCI World Index is up 79%. Meanwhile, the global economy is enjoying its fourth successive year of growth above 4%. Warning: wave watching can seriously damage your wealth.

The great thing about over-arching theory is that it is possible to construct different interpretations. Perhaps we are in the third wave of a super bull cycle. Using the Dow as our market barometer (fitting as Charles Dow is arguably father of technical analysis) the first up-wave ended in 1929 when the index fell from 377 to 228. The next up-wave was 1942 to 1966 (the high of 1929 was only surpassed in 1954). Between 1966 and 1982 the Dow declined 75% adjusted for inflation, the second corrective wave.

The super bull market started in 1982. It will last until 2032, give or take a few years. Why? Because an obscure Russian economist called Nikolai Kondratieff thought there were 50- to 54-year cycles in prices. We are all going to retire rich, unlike poor old Nikolai, who was shipped off to Siberia by Stalin.

It is easy to dismiss the followers of obscure American accountants or Russian economists as head-bangers. However, all technical analysis is a variation on a theme. Whether your particular predilection is for head-and-shoulders, rising wedges, domed tops (no sniggering at the back), island reversals or the dreaded three crows that can ominously appear in Japanese candlestick charts, this ragbag of voodoo analysis is trying to divine meaning from recurring patterns.

There is none. Technical analysis has the same level of intellectual rigour and predictive substance as haruspicy – the study of the entrails of slaughtered animals. The Da Vinci Code is fiction. So is technical analysis. Like the haruspices (entrails readers) of ancient Rome, when you touch this stuff you are delving into nothing more than a load of bloody offal.