Is the Death Cross accurate?

Dear Mr. Market:Death-cross-2

In all of our letters to you it’s been well documented how volatile and irrational you can be. You clearly have a temper and even when there is an abundance of good economic news you can still make us squirm and sweat with how you may react. What compounds your behavior is how traders and investors label certain charts and patterns. Most recently we’ve been alerted that you have signaled another mess on the horizon with an ominous reading of the “Death Cross”.

Could you (and that description) be any more dramatic?!?

The proverbial Death Cross is when a short-term moving average (50 day) crosses to the downside on a longer-term moving average (200 day). Incidentally, the reverse of this is when the short-term moving average passes the long-term moving average to the upside and that is called a “Golden Cross”. Technicians will point to the fact that some of the most brutal bear markets over the past century revealed a Death Cross in their trading patterns. Should we pay attention?

The short answer is yes….(perhaps) if you are an active trader. If you’re a longer-term investor or follow a strategy that is not based on reading tea leaves, the answer is far different.

On Friday the stock market just indicated the first Death Cross since the summer of 2016. What if you had followed the hype of selling your investments at that point? What you would have seen was basically a false indicator. This last Death Cross occurred in the middle of a normal market correction and in retrospect was a fantastic buying opportunity. Those who sold not only missed out on the rest of a good year but a fantastic 2017 as well.

The following points are a few things that will hopefully give you some perspective on whether you need to join the drama or ignore it:

The Death Cross is a Lagging Indicator

A moving average will show a natural lag due to the very nature of what it’s tracking; in other words…it tells us what has already been happening. We’re basically looking back at a certain period of time (50, 100, 200 days etc) and an average is then presented. A lot can happen in just one month but when you extrapolate to averages even on the shorter end of say 50 days…you are essentially showing up late to the party since the trend has already materialized. Those who act on these patterns often pull out of markets right when a buying opportunity is almost at its ripest!

Everybody Knows

While we admit to not relying solely on technical analysis it of course cannot be ignored. We find it ironic that the more something is being reported the less likely it may occur. One could almost use the Death Cross as a contrarian indicator in many instances! (take a peak at the chart towards the end of this article) Much of the process in following patterns becomes self-fulfilling behavior. Everybody is watching the same things nowadays and the idea that seeing this pattern develop before someone else can give you an edge or portend what will happen tomorrow is a bit naive.

What Typically Happens After a Death Cross?

First off let us remind you that there are many parts to the market. It drives us nuts when we hear “the market” and someone is referencing the Dow Jones. (that’s only 30 US stocks and the index is poorly designed to begin with). The Dow, by the way, has given us about 60% false Death Cross indications so if you’re comfortable investing with those odds please do so (just not with our money!).

Speaking of other parts to the market, if we take a look at the Russell 2000 and track how accurate the Death Cross was in predicting a bear market you may not be very convinced in following it any further.

Death Cross (IWM - Russell 2000)

The above chart is just a sliver of recent history but it captures several scary market environments (including 2008) and if you sold out of the market based on what the Death Cross indicated, on average you would have lost immense amounts of money/opportunity just one year later.

Make your own decisions based on what you see out there but at least take into account that just because something has happened before it certainly doesn’t negate all the times it was more hype than reality.

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