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Where is the stock market heading? - Part-2 - Fibonacci Retracements


Stock markets across the globe are registering a raging recovery and we as investors are facing a tough choice of whether to participate in the rally or not. In part-1 we covered why the rally feels superficial as things have not changed fundamentally in the past 2 months. We also looked at historical events to understand how the market reacts in accordance with The Dow Theory and the cyclic nature of the markets. We entered a Bear Market cycle when the index fell nearly 39% from all time high. Based on history, no bear market has ended in just 1-2 months and generally lasts at least an year. In part-2 we will apply Fibonacci Retracements to historical data as well as the current NIFTY charts to see if there are any important price zones to be cautious about.



What is Fibonacci Retracement?


Before we continue, let us understand what Fibonacci Retracement is. It is a fascinating stock market tool having surprising consistency and it is used for forecasting. For those who already know about it, you can skip this and move on to the next section.


Many must have heard about Fibonacci during their schooling days. I was introduced to Fibonacci as a market tool via Zerodha’s Varsity. Below is an excerpt from Varsity explaining about Fibonacci numbers.


 

Fibonacci is a series of numbers that is derived by adding 2 consecutive numbers to arrive at the third number and this process is repeated.


0 , 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610…..


Though the series has been in usage since ancient times, Fibonacci, an Italian mathematician introduced it to the modern world and the series is named after him. The number has an interesting property that when you divide any number in the series by the previous number; the ratio is always about 1.618.


610/377 = 1.618

377/233 = 1.618

233/144 = 1.618


The ratio of 1.618 is considered as the Golden Ratio (Phi). Fibonacci numbers have their connection to nature. The ratio can be found in the human face, flower petals, tree branches, cyclone spirals, galaxial formations etc. Further into the ratio properties, one can find remarkable consistency when a number in the Fibonacci series is divided by the previous number.


89/144 = 0.618

144/233 = 0.618

377/610 = 0.618


At this stage, do bear in mind that 0.618, when expressed in percentage is 61.8%. Similar consistency can be found when any number in the Fibonacci series is divided by a number two places higher.


13/34 = 0.382

21/55 = 0.382

34/89 = 0.382


0.382 when expressed in percentage terms is 38.2%. Also, there is consistency when a number in the Fibonacci series is divided by a number 3 place higher.


13/55 = 0.236

21/89 = 0.236

34/144 = 0.236

55/233 = 0.236


0.236 when expressed in percentage terms is 23.6%.


 

So, that's how Varsity explains it. These percentages, 61.8%, 38.2%, 23.6% are the basis of arriving at Fibonacci retracements. These ratios act as possible retracement levels for the stock prices when there is pull-back, before resuming the original trend. For example, if a stock price increases from 1 to 100, the stock tends to pull back to either 77, 61, 38 before increasing again. Likewise, if a stock decreases from 200 to 100, the stock tends to pull back to either 123, 138, 161 before decreasing again. You could also notice that these levels are approximately ⅓ or ⅔ of the price range under consideration. Psychologically, people look at booking profits or renter stocks at halves or thirds, thus Fibonacci also respects the market behaviour. As stock chart technicians, a great emphasis is laid on these retracement levels to forecast and look for trend reversals.



Forecasting Reversals Zones On The Market


The Fibonacci retracements can be widely found across the stock market. It is astonishing to see that the price action of the indices have respected the Fibonacci levels consistently in the past. To establish this, we will be drawing the Fibonacci levels to see how the NIFTY behaved during the Great Recession of 2008 and compare it with how NIFTY is behaving currently.


Great Recession 2008 - Fibonacci Retracement
Great Recession Fibonacci Retracement

As the first example, let's take a look at the daily chart of NIFTY during the 2008 recession. I’ve plotted the Fibonacci retracement levels starting from the high of 2008 till the end of the first breakdown. This fall is synonymous with the fall that happened in march 2020 when the index fell from 12400 to 7500 levels. Notice that the market first retraced 50% of the fall. Even though 50% is not a Fibonacci number, it has a huge psychological and numerical significance to the market behaviour. NIFTY faced a resistance at 50% retracement and fell gain. The market eventually recovered, broke past the 50% level and almost hit the 61.8% level before resuming the down trend. This is clearly a bear market rally which faced resistance near important Fibonacci levels. If we further plot the market movements, the market went back to the previous low and then retracted back again till the 38.2% retracement level. It eventually reversed again and broke the lows of Jan 2008 to hit new lows.


COVID 2020 - Fibonacci Retracement
COVID Fibonacci Retracement

Above chart is the current NIFTY daily chart tracking the movement from the high of 12400 till the recent low of 7500. Can you notice the eerie similarity of the market pattern with that of 2008? After hitting 7500, the market retracted to 50% of the entire fall, just like how it did during 2008, before facing resistance and moved lower. The only difference this time, is the time-frame. The retracement of 2008 happened quicker, but in 2020, this happened much slower. Today, the market has recovered significantly, causing elevated feelings of Fear of Missing out (FOMO) among investors. But, if you look closer, the market has not yet crossed the 61.8% retracement level, which acted as a significant resistance during 2008 too.


Coincidentally, I noticed only today that the market is hovering between 50% and 61.8% retracement, a level from which the market resumed its down trend in 2008. I am not 100% certain that the market will reverse from these levels, but it is astonishing that we are at this level, when I chose to write the article. Based on history and the effectiveness of Fibonacci, this is a time to be cautious and not give-in to our feeling of FOMO. Until the market breaks above the 61.8% level with force, it is not advisable to invest. The range between 10150-10450 is a possible reversal zone. The 61.8% is not a magic number, hence it is futile to look at it as an absolute number, instead we need to draw zones around the number to look for price actions. The reason is, the stock market is being worked upon by millions of investors and traders, hence there will always be a significant section of market participants who cannot take rational decisions and give in to their FOMO, thereby making the index or stock overshoot or undershoot the Fibonacci levels.


Now that we have seen where the stock market is, at the current juncture, let us look at the bigger picture of attempting to forecast the bear market down-side if the index does reverse from here on. Just to reiterate, this is only an attempt to understand the market behaviour using historical data as reference points. This might or might not happen in reality, but it helps us in gauging the quantum of future moves, and helps us in being prepared for any eventuality. For the historical comparison, we will look at the 2008 bear market again by plotting the chart that extends over a few years.


Great Recession 2008 - Fibonacci Retracement Bottom
Great Recession Fibonacci Retracement Bottom

The above chart is the monthly chart of NIFTY plotted from lows of the Dot-Com Bubble back in 2002 till the market crash of 2008. This chart represents the previous Bull Market starting from 2002-2003 till the 2008 crash. By connecting the low of 2002 to the high of 2008, the NIFTY had grown 8 times. Considering this entire move as 100%, the first reaction that occurred during the months of Jan-Feb 2008, the market had fallen about 38%. Do recollect that 38.2% is the magic number of Fibonacci retracement. The market then recovered up to the 21% retracement level for the next couple of months before resuming the long down trend by breaking beyond the panic lows formed in February 2008. The market finally found a bottom near the 68% retracement level of the entire move from 2002-2008. Every Fibonacci level was respected by the market during the recession.


COVID 2020 - Fibonacci Retracement Forecast
COVID Fibonacci Retracement Forecast

Now, above is the monthly chart of NIFTY plotted from the lows of the 2008 recession till the COVID market crash of march 2020. This chart represents the Bull Market starting from 2008-2009 till the 2020 crash. If we apply the Fibonacci levels, NIFTY has already hit the 50% retracement level (7500) from the lows of 2008 and rebounded after finding a support near the 38.2% retracement level. There is an uncanny repetition of these important psychological and Fibonacci levels, every time we analyse the important price action zones. It is quite evident to note that, even after a decade of Bull run, the market is mean reverting to the Fibonacci numbers with such consistency. That raises the question, why can't history repeat itself, if there is such consistency shown even today? Assuming that this is just a Bear market rally (No solid reasons for this rally in the first place), if the market continues the down trend, there are few possibilities to consider. Firstly, the market can hit the 38.2% or 50% retracement again before rebounding, thereby signalling the end of the bear market rally. Or, the market could break the 50% retracement (7500) and it could find itself in a more severe draw-down, falling till the 61.8% retracement which is 6300-6400 zone. Also, note how neatly the 61.8% retracement aligns with a strong support line which has a significant price action dating back to 2010 and 2013. Generally, a prior resistance level will act as a support level when it's broken. So, if the market breaks the previous low of 7500, watch this zone. Beyond this, you have another retracement zone at 78.6% ranging between 4600-4700. This level may be of some importance because, during the 2008 bear market, the market eventually formed at a bottom at 78% retracement level.


Despite these levels indicated by Fibonacci, there is no need for panic. Even Fibonacci has failed to correctly forecast in the past. Hence, for these levels to become probable targets, NIFTY should breach 7500 first and let's hope that doesn’t happen. But keep these levels in the back of your mind.


To sum it up, we are at a crucial juncture with Nifty closing at 10142 on June 5th 2020. We are very close to a reversal zone as per Fibonacci Retracements, that makes it counter-intuitive to give way for FOMO. The down-side risk is too high at this point that the risk to rewards ratio is totally skewed towards losing money. The eventual down-side targets are too far away and it is better to remain on the sidelines to observe for the next few weeks, before taking a decision.


Before I close out, there were obvious comparisons being made to the global markets and how NASDAQ has recovered all losses of this year. DJIA has recovered 87% and so are the other global indices such as Nikkei, DAX etc. The US has given new data of how new jobs were created in the month of May and reducing unemployment rates. Does that mean the global economy is out of the woods? Maybe yes, but we are yet to receive the entire set of economic data to arrive at a conclusion that the bear market is over. Hardly 1 financial quarter has passed to come to that conclusion. The optimism of ending lock-down and the expectation COVID vaccines has driven the rally in global markets. But for the rally to continue, there needs to be a fresh trigger of quantifiable economic data. For the Indian market’s perspective, it has under-performed the global peers thus far with the FII pulling the strings as usual, on the upside as well. It is prudent to wait for a few weeks to observe the market and also to wait for additional economic data. Because, if the global markets were to reverse now, it is a Double Top that is in the making for the global indices.



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