Rallies And Fibonacci Retracements

05/27/05 07:58:13 AM

by David Penn

Smashing past the 50% retracement level, the Standard & Poor's 500 races toward a test of year-to-date highs.

Security: $SPX
Position: N/A

Will the last bear in the market please turn out the lights?

Or at least turn down the volume on CNBC? I had the opportunity to spend an entire morning and afternoon listening to little more than the barkers of everyone's favorite financial channel the other day, and it's a wonder how anyone could possibly remain bearish in the face of their "If wishin' made it so" brand of optimism.

Besides, traders and speculators hardly needed CNBC's stock market cheerleading to stay away from bearish bets here in late May. And while there are a number of ways of telling the story of our spring-bounce-come-lately (a few of mine, from Traders.com Advantage, include "The OEX's 1-2-3 Trend Reversal," "QQQQ Channel Pairs," "Will Divergences Doom The Rally?," "Hammers On High Volume," "and "Projectile Bottoming"), one of the more fundamental ones can be reached simply by asking: How much of the previous decline will the May bounce retrace?

Figure 1: $SPX. Closing above the 61.8% retracement level in the days before the Memorial Day weekend and besting the April highs, the S&P 500 is primed to make a run on the 78.6% retracement level at 1210 and, perhaps, a test of the year-to-date highs near 1225.

Graphic provided by: Prophet Financial, Inc.

So far, the answer to that question is: Plenty (Figure 1). There are a number of gauges to use in determining the strength of retracements. One popular one is the 50% principle, which has been around for as long as Dow theory itself and suggests that a market that retraces more than 50% of a previous decline tends to be a market that stands a decent chance of retracing a great deal more. Another gauge looks to recent peaks. If a retracement takes out more than one previous, significant high, then the retracement is thought to have particular strength.

But one of the more popular retracement gauges is to use Fibonacci retracement levels. These levels are based on Fibonacci ratios--or at least the most common ones--of 0.382, 0.500, and 0.618, as well as two more such ratios between 0.382 and zero (0.236) and 0.618 and one (0.786). Writing about Fibonacci ratios, Elli Gifford notes in her book, The Investor's Guide To Technical Analysis:

The ratios are a very popular method of calculating likely retracements among market traders, with 61.8 per cent (0.618 x 100), 38.2 per cent (100-61.8), and 50 per cent (1:2) being the most commonly used. ... It is interesting to note that these numbers are very similar to the 2:3, 1:3, and 1:2 retracements Dow estimated were likely. If one of these retracement levels gives way, prices are projected to the next.

Looking at the advance in the Standard & Poor's 500 since mid-April, it is interesting to note how the market progressed as it ran into potential resistance at the various Fibonacci retracement levels. For example, note how the S&P 500 reversed on the first two attempts to breach the 23.6% level in late April. After breaching the 38.2% level in the first half of May, the S&P 500 moved sideways for a few days before dropping sharply back. This pullback was severe enough to force a close back below the 23.6% level, and likely sent more than a few weak-kneed bulls back to the pen.

As the uptrend gained more adherents (that is, more buyers), the market was better able to handle the hurdles it passed as it moved higher. Once it broke out above the 50% retracement level, for instance, the S&P 500 consolidated, but did not slip back beneath that level even on an intraday basis. The 61.8% retracement level has proven to be more of an obstacle than the 50% level was. But compared to the experience at lower levels, the 61.8% level is no Fenway Park "Green Monster." The S&P 500 penetrated this level a few times on an intraday basis first, before moving up and closing above this level on May 26.

While a pullback at this point is possible, there is greater and greater support below the market to support further advances. The low of the current four-odd day consolidation serves as the most immediate potential source of support (near 1185). Below that, there is support in the form of the highs from the first half of May just shy of 1180. Should the S&P 500 have a mind to go higher, it is hard to believe it will waste much time with these lower levels before doing so.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Rallies And Fibonacci Retracements

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