Which came first the “The Fed Decision” or the “Stock Market Reaction”?

The predictable responses investors have to normal human emotions may be behind the details of modern day technical analysis.

A New Era… In this new investment environment where so much of the movement in financial markets is driven or seemingly driven by the Federal Reserve and now Central Banks around the world, the question of who is driving the direction of decisions in financial markets is more important than ever.

The Fed… Is the Federal Reserve taking cues from the market and incorporating this data into their decision process, thereby being effectively driven by the Markets? Alternatively is the Market hanging on every word of each FOMC announcement and driven by decisions taken by the Fed? Maybe it is more irrational and somewhat less linear than either of the prior questions would lead you to believe. It’s possible that each is reacting to the other in a way that is more easily explained through the application of Sigmund Freud’s psychoanalysis. Edward L. Barneys, the acknowledged father of public relations and nephew of Sigmund Freud through the application of psychoanalytic principles to public relations and advertising made some interesting discoveries that relate to this topic today. Bernays’ unprecedented success stemmed from the notion that irrational forces drive human behavior. Barneys hypothesized that by understanding the group mind, it would be possible to manipulate people’s behavior without their even realizing it. To test this hypothesis, Berneys launched one of his most famous public relations campaign: convincing women to smoke.

“Irrational Exuberance”… It could be said that investing stirs up some of our strongest emotions and so as a group the investing community is inherently susceptible to reacting irrationally and responding predictably to common human emotions such as fear, greed or prestige. This brings me to my point about technical analysis ultimately being driven by the irrational responses of the crowd mentality. The use of the Fibonacci number sequence or “Fibonacci Numbers” or “Fibonacci Sequence” is one of my favorite technical analysis applications for financial markets. This is because the amazing origins of the Fibonacci numbers and the unbelievable way they are found throughout nature. Fibonacci numbers can be found in the design pattern of the golden spiral, the branching in trees, the arrangement of leaves on a stem, the fruitlets of a pineapple, the flowering of the artichoke, the uncurling fern, and the arrangement of a pine cone and even the family tree of honeybees. With such prevalence in biological settings, it is easy to make the generalization that what we think of as irrational investment behavior is a deeper response to more base level human emotions that are much harder to control as individuals.

Why is it so hard to do the rational thing?… I like to bring up how it seems to be so difficult for Americans to lose weight. Conventional wisdom is that being overweight is unhealthy and there is a ton of empirical evidence supporting this line of reasoning. However Americans from a crowd behavior perspective seem to behave irrationally when it comes to eating and being overweight. Obviously advertisers are taking advantage of this little bit of predictability, which is why there is a McDonald's on almost every main street in almost every town in the country.

Follow the Crowd… Investing and putting capital at risk is a very emotional activity, anyone who has ever put on an investment and won big or lost big or even not made the amount of return they were expecting can attest to the flood of emotion that consumes you while invested. It is for this reason that I believe there is the predictability of the crowd mentality and the irrational responses of the crowd at work in the financial markets, which is what makes technical analysis so useful. If humans respond in a predictable irrational way due to more base human emotional responses to fear, love, greed, envy etc. then the application of a mathematical sequence that also predicts the basic sequence of many natural biological occurrences also makes sense. I like using the Fibonacci numbers and the wide array of mathematical calculations that have become standard technical tools in almost every online trading platform on the market because they are so easy to put on your charts and you can quickly see how the patterns have correlated to market movements of the past and then make a few quick extensions to find some likely scenarios for price and volatility in the near future. A perfect example of this is the Fed announcement expected this coming Tuesday April 26th and Wednesday April 27th. There are a few simple Fibonacci extensions if applied to the Daily chart of the S&P500 (S&P E-Mini June futures contract) that line up at the exact same spot. Tuesday April 26th and 2090 price. Is it a coincidence that the Fibonacci time extension just so happens to line with the next FOMC announcement? I think that there may be something more going on beneath the surface here as it relates to investors tolerance for waiting for information from the Fed which has driven the decisions of the Fed about how often they will publicly announce the results of their Federal Open Market Committee meetings. Remember it was not that long ago that the Fed was very guarded with information and did almost no announcements to the public.

Conclusion… Below is a chart with just a few simple Fibonacci time and price extensions, but it is interesting to note that since the beginning of the year, there is a consistency to the way market direction changes have lined up with these time and price extensions. If you are so inclined I encourage you to do the research for yourself and make your own conclusions. For my part, this application of technical analysis founded in the roots of the psychology that has been driving Western culture for the last 100 years has so far been producing a trading strategy that has a 78% win/loss ratio.

Thank you for spending your time with me and I hope you enjoyed this.