The ultimate goal of any market-timing investor is to stay in sync with the natural rhythms of the market. Fortunately, there’s a popular analysis tool I use to do just that.
It’s based on the work of a brilliant 12th century mathematician named Leonardo Pisa. Basically, Pisa described the natural mathematical “order” inherent in a wide range of systems.
To over-simplify his work, one premise of his was that organic systems can be roughly divided into segments of two-thirds and one-thirds. Specifically, Pisa’s work was based on Fibonacci numbers, sequences and ratios.
Over the years, thousands of investors looking to tune into the market’s wave-like moves have adopted these relationships. Here’s just one example of Fibonacci numbers in action. Take a look at this chart…
As you can see, by mid-2009 it became clear the stock market recovery was “game on.” Without taking a breath, the S&P 500 shot 82% higher in 13 months. That move was simply unsustainable because the market must exhale as well.
Under these circumstances, a wise tactic would have been to wait for a pullback, then buy when the uptrend resumed. Fibonacci retracement levels give traders a useful way of estimating just how deep a pullback like this would be.
The rule of thumb is that a pullback will retrace a minimum of 38.2% – about one-third – of the predominant trend. As you can see, this happened in April 2010 when the market started losing steam. It was due for an exhale and was sure to retrace part of the strong uptrend.
The question was – how much? Anyone following Fibonacci retracements knew the best time to go long again. In July, the S&P hit the 38.2% Fibonacci retracement level and immediately turned higher. After that, the uptrend was back on and the S&P gained another 36% in 10 months.
If you’re a trend-following trader, as I am, you should definitely learn to use Fibonacci retracements as one tool in your arsenal. The tool isn’t a magic bullet. But it provides a great of judging the best way to buy a dip in a strong uptrend.