How To Use Market Sentiment To Improve Your Trading/Investing (Part 4)

Until the times of R.N. Elliott, the world applied the Newtonian laws of physics as the primary analysis tool for the stock markets.  Basically, these laws provide that movement in the market was caused by outside forces.

Newton formulated his laws of external causality into his three laws of motion: 1 – a body at rest remains at rest unless acted upon by an external force; 2 – a body in motion remains in motion in a straight line unless acted upon by an external force; and 3 – for every action, there is an equal and opposite reaction.

So, the common belief was, and, unfortunately still is, that a stock will remain in motion in a straight line, unless something acts upon it, like news or earnings, to change its direction. 

However, as Einstein stated: “During the second half of the nineteenth century new and revolutionary ideas were introduced into physics; they opened the way to a new philosophical view, differing from the mechanical one.”

However, even though physics has moved away from the Newtonian mechanical viewpoint, sadly, our financial market analysis has not.  In fact, how often do you see good earnings come out for a stock, yet the stock tanks?  Well, we justify it by saying that they “sold the news.”   But, it then leaves you with the reasonable question as to how do you know if good news will cause a good reaction in a stock or a “sell the news” event?

As we all know, most market participants are looking for the next piece of news that is supposedly going to move the market.  So, when they hear a positive news event being reported, they automatically assume that the market will respond positively.  But, we have all seen markets sell off on positive news. 

And it has had many market participants scratching their heads in disbelief, and, it unfortunately causes losses in their trading accounts.

In fact, I can no longer count how many times I have heard fundamental analysts claiming that a market rally or decline just does not make sense or is wrong based upon their fundamental analysis.  I mean, how many times have we heard analysts state that the market is just not trading based upon fundamentals at this time.

As some of you may know, I used to write for Seeking Alpha.  And, I was constantly barraged by the arguments that fundamentals are what drive the prices of metals, but they are just not acting upon fundamentals right now.

Folks, I have some news that many of you will not accept.  If fundamentals do not move the market all the time, then they are NEVER really in control of the market any of the time.  And if after 3 years of supposedly ignoring the “fundamentals,” the metals will now rise along with the "fundementals being in line," does it not mean that the fundamentals are only coincident to the metals rise, as the market has been dropping despite the "fundamentals?"  If they could not prevent the fall of the metals, then logic dictates that they really are not causing any rise.

As Elliott put it, “In the dark ages, the world was supposed to be flat.  We persist in perpetuating similar delusions.” 

Elliott urged that we move away from such misdirected analysis and view that external events affect the market only insofar as they are interpreted by the market participants.  Such interpretation is guided by the prevalent social mood internalized by the investor community as a whole. 

Therefore, the important factor to understand is not the social event itself, such as the news, fundamentals, or the earnings, but, rather, the underlying social mood which will provide the “spin” to an understanding of that external event or information.

During his tenure as the Chairman of the Federal Reserve, Mr. Alan Greenspan testified many times before various committees of Congress.

In front of the Joint Economic Committee, even Mr. Greenspan noted that markets are driven by “human psychology” and “waves of optimism and pessimism.”  And take note, he did not say that markets are driven by fundamentals.  He very clearly noted that it was psychology and waves of sentiment that moved the financial markets.

This simple premise now explains why markets sometimes rise when seemingly bad news or fundamentals have been announced and why markets go down when seemingly good news or fundamentals have been announced.  When the social mood is within a positive trending wave structure, bad news is seemingly “discounted” and only good news is seemingly focused upon.  And the reverse is true during a negatively trending social mood.

So, is it really the news or the fundamentals that are moving the market?   The answer is obviously “no.” It’s the prevailing sentiment which interprets the news or fundamentals that moves the market.

Elliott theorized that public sentiment and mass psychology move in 5 waves within a primary trend, and 3 waves within a counter-trend. 

Once a 5 wave move in public sentiment has completed, then it is time for the subconscious sentiment of the public to shift in the opposite direction, which is simply the natural cycle within the human psyche, and not the operative effect of some form of “news.”

This mass form of progression and regression seems to be hard wired deep within the psyche of all living creatures, and that is what we have come to know today as the “herding principle,” which gives this theory its ultimate power.

But what gives Elliott Wave analysis the power to determine where those turns in public sentiment will occur is Fibonacci mathematics.

Allow me to take a few minutes to digress a bit into who Leonardo Fibonacci was and the significant impact he left upon our world.

After the fall of the Roman Empire in 476 C.E., much of European advancement in mathematics and philosophy was either lost or simply remained stagnant. Although there is a difference of opinion among historians regarding the classification of the period after the fall of the Roman Empire, this period became commonly known as the Dark Ages. Among recent historians, the Dark Ages lasted until around the 10th century.

Around 1170 C.E., Leonardo Pisano Bigollo, or more commonly known as Leonardo Fibonacci, was born to Gugliemo Bonnacci, a wealthy Italian business man. To give you some reference during which times Fibonacci lived, the Leaning Tower of Pisa was being constructed at the time.

While Leonardo was still quite young, his father was appointed as an official at a port east of Algiers in North Africa. It was not long until Leonardo was traveling with his father through the Mediterranean.

It was during this period of time that Leonardo learned about the Hindu-Arabic numeral system, and recognized that these numerals were simpler and more efficient than the Roman numerals being used in Europe at the time.

It was not long thereafter that he published his famous book Liber Abacci (Book of Calculation). This book was a key turning point in European mathematics, as it introduced the European community to one of the greatest mathematical discoveries of all time, namely, the decimal system, in addition to the numeric system which we still use to this day. This was considered to be the most important advancement in mathematics since the start of the Dark Ages.

Also included in his major work Liber Abacci, Fibonacci worked through a mathematical problem which led him to the discovery of what we call today the Fibonacci sequence, which is based upon Phi, or the Golden Ratio. 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, etc.

Within this sequence, each higher number is the sum of the prior two numbers, and the ratio of any two consecutive numbers approximates 1.618 or its inverse, .618. The higher you move through the sequence, the closer you move towards the 1.618/.618 relationship.

This .618 number has been referred to as the "Golden Mean" throughout history. We also refer to this number as Phi.

Phi is a number which exhibits many unusual mathematical properties, and is also the solution to a quadratic equation. These concepts have been understood by Plato, Pythagoras, Da Vinci, Kepler, Bernoulli, and Newton.

Historic structures have been built by architects of famous Greek structures, such as the Parthenon, based upon the concept of Phi, and even as far back as the architects of the Great Pyramid of Giza in Egypt, who recorded their knowledge of Phi as the building block for all man nearly 5,000 years ago.

What makes Phi even more unusual is that it can be derived in many ways and is exhibited in relationships throughout the universe, such as proportions within the human body, plants, DNA, the solar system, music, population growth, and, yes, the stock market.  Phi is the one underlying constant throughout all of nature and governs all the laws within nature. In fact, the greatest minds of history, such as Pathagorus, Plato, and Kepler, all felt that Phi was the key to the secrets of the universe.

In 1941, Elliott stated, regarding the financial markets, that ““These [Fibonacci] ratios and series have been controlling and limited the extent and duration of price trends, irrespective of wars, politics, production indices, the supply of money, general purchasing power, and other generally accepted methods of determining stock values.” 

In recent times, we have seen evidence that Phi even governs man’s decision making.  Social experiments have been conducted which resulted in price patterns, based upon a mathematical standard, that mirror those found in the stock market.

As, I noted last weekend, in 1997, the Europhysics Letters published a study conducted by Caldarelli, Marsili and Zhang, in which subjects simulated trading currencies, however, there were no exogenous factors that were involved in potentially affecting the trading pattern. Their specific goal was to observe financial market psychology “in the absence of external factors.”

One of the noted findings was that the trading behavior of the participants were “very similar to that observed in the real economy,“ wherein the price distributions were based on Phi.

In a different study conducted at the School of Social Sciences at the University of California, they came to the conclusion that “We may suppose that in a human being, there is a special algorithm for working with codes independent of particular objects.”  Specifically, when subjects were asked to sort indistinguishable objects into two piles, their decision making within that process divided the objects into a 62/38 ratio.  In other words, these individuals exhibited a Fibonacci tendency in their personal decision making.

Therefore, there is significant evidence that behavior and decision making within a herd and on an individual basis displays mathematically driven distributions based on Phi.

This basically means that mass decision making will move forward and move backward based upon mathematical relationships within their movements.  This is the same mathematical basis with which nature is governed.  The same laws that were set in place for nature also govern man’s decision making en masse, and on an individual basis.

Now we know that movements in markets occur due to waves of sentiment, as discovered by R.N. Elliott, and we know that decision making and changes in trend are governed by Fibonacci mathematics and the properties of Phi. Next week, we will show you how we apply this information to our own trading to generate profits.

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See chart illustrating Elliott Wave's pattern of 5 waves up and 3 waves down, plus detail on Fibonacci Pinball.