Golden ratio spells doom for Dow

There are few stranger subjects in fund management than charts and the extent to which they can be used to predict market movements. Like Druids with their runes, chartists analyse the ups and downs of the markets and see patterns where the rest of us only see a lot of peaks and troughs. What cannot be denied is that there are cycles. Economies and markets boom and crash with depressing regularity. The question is whether there really are any discernible trends. David Franklin, director of retail funds at Christows and primary manager of the company’s Managed Growth, Overseas Growth and Worldwide Growth funds, is one of those who believes there are patterns. The key graph to analyse at the moment, he says, is the Dow Jones since its spring 2000 peak. At present, the Dow is facing a point of critical resistance, as defined by the declining trend line X drawn from subsequent peaks (see graph). The latest rally from the March 2003 lows can be measured by the formula, C = B + (1.618 x A), where the peak at C is broadly equivalent to 7401 plus 1.618x the previous rally of 1864 points. The model predicts a peak of 10,417 and in practice the Dow overshot to 10,702. Within three days, however, it had settled at 10,404, just 13 points below the forecast level. The number 1.618 is the Fibonacci golden ratio, which has been well documented as a factor commonly found in nature, art, geometry, architecture and music. Franklin says: “Somehow the market knows that line is there. I cannot explain how but the Dow has been attracted to that line like a magnet, and since the beginning of 2004 it has oscillated around it, deciding what to do next.” It is also possible to add a support trend line to the model. Support and resistance levels are commonly used by market traders and are also drawn up using Fibonacci ratios. It may be that they go some way to explaining market movements because they generate self-fulfilling expectations. Franklin maps the support line using the last two low points on the Dow (see line Y below). Franklin says there are three possibilities to the Dow’s future direction. The first and most optimistic possibility is that there is one more rally left in a five-cycle movement that began way back in 1982. If the Dow managed to break above its current resistance level, defined by the upper trend line, then there would be no higher trend lines to act as resistance. This would mean a “blue-sky breakout” that could go as high as 12,800, according to Franklin’s calculations. The second alternative is that the Dow slips below the upper trend line and becomes rangebound in the triangle formed by the upper and lower trend lines. “If that were to happen we would have volatile and weak markets trapped inside the triangle for many months. That is also quite possible and we need to be aware of it,” he says. The third and final possibility is a sharp fall that takes the Dow down through the triangle and below the lower support level. This would take markets to very low levels and would be associated with a severe deterioration in the economy, which Franklin thinks is unlikely just yet. So we can conclude that the Dow will either go up, down or stay at roughly the same level. But perhaps this facetious observation is a little unfair. Franklin freely admits that he does not have blind faith in charts; it is just that at present the Dow looks very much as though it is ready for one more last-gasp rally in the classic Elliott five-cycle sequence. And what would support such a last-gasp rally? Franklin believes the US election later this year is key. The government is doing all it can to make Americans feel good, cutting taxes and increasing spending. Franklin says: “When people feel wealthy and lucky, the market goes up. After the vote, people may realise things are not as good as they thought.” He believes that in the next 18 months or so, equities will reach a peak. That is the good news. The bad news is that they will not revisit that peak again for 20 years. He is one of those who believe that a serious depression lasting years will occur because the massive personal and government debt will become too much for the economy to bear. The difficulty many people have with chart theory is that it has no basis in the real world. Arbitrary events such as 9/11, Enron and the Gulf war can put markets into a tailspin irrespective of what chartists say should happen next. Nor are charts necessary to work out that equities tend to do well in presidential election years and that the growing debt problem could cause major economic problems next year. But to use charts you have to understand that they are based on human behaviour and not fundamentals. Franklin says: “Charts are just plotting investor psychology, and that is repeated all over the world. Charts help us tremendously at Christows but we also use all the other standard fund management tools. And no system anywhere can give you a warning about events such as September 11. That is just part and parcel of the risks you take with investing.”