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Now that's something we can all chew on!

Yesterday, after penning a piece on the mathematical and historical background of the Fibonacci sequence, we promised to answer the question of how this applied to negotiated financial markets like stocks, bonds, commodities, etc. So here goes.

We mentioned yesterday that phi relationships can be found everywhere in nature, everywhere in "complex" systems. In patterns displayed by almost any complex organism: fruits, trees, flowers, quarks and neutrinos as they disintegrate, hurricanes as they spiral, the great Egyptian pyramids, music, and the form of galaxies in space: all are governed by phi. Of course, humans too have plenty of phi relationships in our bodies: at miniscule scales like our DNA molecules to macro scale relationships such as the fact that our navels separate our bodies' height into a perfect phi relationship (navel to top of head = .618, navel to bottom of feet is 1.00). There are plenty of others, indeed they are almost limitless within the human body.

The defining principle of phi in nature is that of order and form upon a complex system: as I suggested in yesterday's article, phi provides for an efficient (in fact the most efficient) "rule" upon which natural progress and egress are made. The budding and growth of a flower, the shape of a sea shell, and the spiraling movement of a galaxy. And importantly, this "rule" applies at all degrees of scale: from subatomic quarks all the way to entire galaxies. The basic phi-based "structure" remains the same, no matter how large or small a thing you are looking at. As importantly, one can "predict" with a high degree of certainty how an organism will "look" as it matures, since it is following a phi-based pattern that repeats itself at increasing degrees of scale.

We know that negotiated financial markets, for stocks, bonds, commodities, currencies, what have you, are merely representations of man's economic activities. A buyer or seller negotiate to determine a price upon which both of them agree is best based on the desire to transact. As I have commented before, plenty of factors go into this decision-making process: both logical/rational assessments driven by the cortex (fundamentals, etc.) and psychological assessments driven by the limbic system (fear, greed, optimism, pessimism, etc.).

Importantly, given that the human form is everywhere a phi-based organism, it stands to reason that the very rational and psychological mental processes he uses to construct his buy or sell decision in the marketplace will be governed by phi as well. In other words, since man's brain is entirely phi-based in its form, in the processes that govern its activity, and in its manifestations (like mathematics, music, architecture, etc.), it stands to reason that, just like man's phi-based brain created phi-based art, music, and architecture, that same phi-based brain will produce phi-based patterns in financial markets. A more complex way of saying this is that man's aggregate financial decision-making processes will follow phi-based patterns in their outcome.

And indeed, they do. That, Minyans, is the heart of the theoretical basis for Elliott wave analysis: the interaction of phi-based human cognition and decision-making in the market produces a price history that conforms, at all degrees of trend from 1 minute to yearly charts, to a phi-based pattern of "waves" or "fractals" or "patterns" that can be "predicted" based on their current form. Ralph Nelson Elliott called them waves, but ultimately it doesn't matter what we call them, just as long as the patterns conform to phi relationships between and among themselves. And for the stock market, they do. Elliott wave analysis then is really "applied phi."

So here's the logic train summation of what I've just written:
(1) All complex (natural) systems are governed by phi in form and movement (fact)
(2) Man himself is a complex system (fact)
(3) Both man's construction and organic processes (digestion, mentation, etc.) are governed by phi (fact)
(4) The collective interaction of man's mentation and the resulting product (e.g. stock prices) is governed by phi (postulate)
(5) The resulting product can be analyzed and predicted based on that phi-based pattern (postulate)

The complexity of what I have just written cannot possibly be done justice in a simple article like this; my goal was to simply introduce the foundational principles behind phi and how and why it can be a useful tool in the management of money. A list of book titles can be found at the bottom of this piece for further reading. I highly suggest them for no other reason than the intellectual sweating and mind-bending it will stimulate. Even if it doesn't do you any financial good, it will certainly be interesting reading: I guarantee it.

My own path to technical analysis in general and phi-based (Elliott wave) technical analysis specifically was by way of frustration as much as curiosity. In a 10 year career as a sell-side research analyst, half of that time (1997-2002) was spent almost fruitlessly in the pursuit of fundamental analysis that provided almost zero advantage in determining the likely future prices for the stocks I was covering. Fundamental analysis was not able to "capture" the fact that, at times, collective psychology (bullish or bearish) is a greater driving force behind the prices of assets than are fundamentals. The long history of stock prices is a catalog of evidence for this view. Indeed, some purists would argue that it is the only driving force behind the prices of negotiated assets like stocks.

Clearly the great bull market of 1995-2000 was decidedly not driven by economic fundamentals. So my attempt to find a tool or tools to measure the power of collective psychology, to measure the herding, self-reinforcing aspect of the price discovery mechanism, led me to phi. It led me to Tom Demark's work and to Elliott wave theory, both of which are based on the understanding that stock prices reflect phi-based patterns. To my knowledge, I believe I am the only one to have "married" these two technical tools in a way that addresses the major weakness that each has, and thus why I call my process "proprietary." Hopefully this exposition on phi will help you develop a technical toolset of your own. And even if it doesn't, understanding that the stock market is governed in whole or in part by phi relationships gives you an edge that 99% of investors simply do not have.

Recommended books:
The Golden Ratio by Mario Livino
Elliott Wave Principle by Frost and Prechter
The Wave Principle of Human Social Behavior by Prechter

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