How the death cross can tell you when to get out of the market
By
Dominic Frisby Jun 30, 2010
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"Watch out for the 'death cross'" ran the title of Saturday's Money Morning round up.
But what is a death cross? What does it indicate? And just how reliable is it?
These are pretty pertinent questions. We have death crosses forming across global markets – confirmed in Japan's Nikkei and the Shanghai Composite; forming in the FTSE 100; in oil and in copper; and looking likely in the Dow, Nasdaq and S&P 500.
So let's take a look at this commonly-used technical indicator in today's Money Morning – and find out what it means for your investments…
What is a 'death cross'?
First, I'll explain what it a 'death cross' actually is.
The 200-day moving average (200 DMA) shows the average price over the last two hundred days. The 50-day moving average (50 DMA) does the same but for the last 50 days.
When the 200-day moving average is sloping down and the 50-day moving average crosses down through it, you have your 'death cross'.
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When the 50-day moving average crosses back up through the 200-day, you have your 'golden cross'. That's your signal to buy back in.
It's not much use for day-traders, but it has proved a reliable indicator for those who look at the intermediate term. So-called 'trend-followers' particularly like it. It won't catch bottoms or tops, but it helps catch the major part of a move.
Let's look first at the CRB, the commodities index, since 2000.
You can see four death crosses. There was one in early 2001, (resulting in a decline from above 230 to below 200); in summer 2006; in summer 2008 (catching a 50% decline from around 400 to around 200); and late last month, we got another death cross.
Much of the correction of late 2006 had already happened by the time the death cross occurred. If you bought back on the golden cross 'buy' signal a few months later, the trade was more or less flat.
But in 2001 and 2008, the sell worked well. The golden cross buy signal had you going long in early 2002, early 2007 and mid-2009, all of which were successful entry points.
I should stress, however, that for a 'death cross' to be valid, the 200-day moving average must be sloping down. There are occasions when the average is sloping up, and the 50-day moving average crosses down through it. This is an incomplete signal, and one should wait for the moving average to turn down for confirmation.
Here is a chart of the FTSE 100 since 2003. There has only been one proper death cross in that time, which came in spring 2008 when the FTSE was around 6,400. Two false signals came in summer 2004 and late-summer 2007. These were actually followed by rallies. It would have been wise to wait for the 200-day moving average to turn down.
What is notable is what an excellent buy signal the 'golden cross' – marked by the blue arrows – has proved to be.
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So what's happening in the markets now?
So what's happening now? Well, last week, the FTSE made an unconfirmed 'death cross', in that the 50-day moving average passed down through the 200, but the 200 is still sloping up, if only slightly. However, a few more weeks trading around current levels will see the 200-day moving average flatten and turn down, in which case we have our sell signal. Should the 50-day pass up through the 200, however, we will have a buy signal. A sustained rally would bring this about.
In the US indices, the 50-day moving average is falling fast and the 200 is starting to slope down, but they have not yet crossed. We should have a couple of weeks or so to wait. Below is a chart of the Dow. The blue line is the 50-day moving average, and the red line the 200. There would have to be a fairly sustained rally to stop that cross from happening – and a sustained rally doesn't look on the cards for now..
The reason I maintain that the 200-day moving average must be sloping down is that otherwise the death cross is not such an effective signal. Since 1962, the S&P 500 has seen 25 occasions when the 50-day moving average has crossed down through the 200. Of these, 13 have resulted in continued declines. That's little better than 50:50.
However, if you only count the incidents when the 200-day moving average was declining, suddenly the probability of a successful trade increases: "you rule out nine of the 12 poor signals, delay three of the accurate ones by a few days and only miss two of the good ones", says technical analyst Ross Clark of Institutional Advisors.
For now, the death cross sell in the FTSE is pending, as is that of oil and copper; that of the Nikkei and the Shanghai Composite are confirmed, while those of the US indices are imminent.
I have been saying for many weeks now that these are traders' markets, that the volatility should deter investors and that I would not be a buyer. Now it looks like a confirmed, intermediate-term sell signal – and a sustained bear market – is just around the corner.
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Dominic Frisby
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