"The Death Cross" sounds like a bad horror movie. Some on Wall Street believe that it's a precursor to a real-life horror show, starring your stock portfolio as Hapless Victim #1. Others believe that it's a mindless exercise in chart watching. Brett Arends of MarketWatch called recent death cross concerns "pure voodoo."
What is a death cross, and why are people so concerned about its effect?
A death cross occurs when a long-term moving average of a particular stock or an index falls below a shorter-term moving average. Typically this refers to the 50-day and 200-day moving averages. By definition, it indicates an intermediate-term downward trend. The big question is whether it is a precursor of a prolonged bear market, or even a crash.
The Dow Jones Industrial Average experienced a death cross last week, prompting speculation that the long-predicted bear market may be near. Pessimists pointed to the fact that the Dow Jones Transportation Index and the NYSE Composite also experienced a recent death cross and that the S&P 500 is extremely close to one (as of this writing). If multiple indices are falling, how can it not be a bad sign?
Others look at the death cross as no better than a coin flip as a predictor for a major downturn. Bespoke Investment Group looked over the past 100 years and concluded that the Dow tends to bounce back after a death cross "more often than not." In the short term, there is a modest downturn, as there almost has to be from the basic math of averages. The downturn averages 0.17% in the next month after the death cross and 1.52% three months after the cross — hardly a reliable harbinger of a bear market.
There have been four recent death crosses before this one: 2004, 2008, 2010, and 2011. Only one of those was associated with a bear market. There are more death crosses than bear markets. It is worth pointing out that the one bear was a big one, with over a 50% drop in the Dow after the January 2008 death cross. Recent drops have been significant such as the almost 6% drop six weeks after the July 2010 death cross. It may not be a bear market, but losses were significant.
One popular indicator is to discount the death cross unless both the 50-day and 200-day averages are sinking as the crossover takes place. The premise is that if both short and long-term trends are down, a bear must be coming. However, the sinking 200-day average premise did not predict the 2008 bear market. Bear markets are often the result of valuation bubbles popping in rapid fashion, where trend analysis is actually counterproductive.
The significance of the death cross may have changed with increased daily market volatility. Moving averages act as a smoothing factor to spot the truly long-term trends. The more days that are averaged, the greater the smoothing effect. Perhaps in the future something like a comparison of a 300-day vs. 100-day average would be more meaningful.
As an investor, should you flee the clutches of the death cross or laugh it off as mere nonsense? You should do neither. Treat it as what it is — a negative indicator amid many other complex factors. Look for the underlying reasons for the death cross and whether those reasons, combined with other factors, lead you to believe the market will continue to fall. Then, and only then, should you retreat from stocks and view the economic carnage from a safe distance.
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