A Market Indicator That Predicts Nothing
Its predictive value is minimal.
Bloomberg, April 29, 2015
One of the themes we like to touch on in this column are heuristics. Myths that become Wall Street rules of thumb have existed for as long as there have been trading desks. They are legion, they pop up regularly and most of the time they are terribly wrong. Woe to the unwary trader who relies on the urban legends to inform an outlook.
We have at various times examined the Hindenburg Omen, NYSE margin, economic conspiracy theories, buybacks, sentiment, single-factor indicators and more.
Many of these trading myths now come with what looks like the imprimatur of quantitative analysis. But as British Prime Minister Benjamin Disraeli is reputed to have said, “There are three kinds of lies: lies, damned lies, and statistics.” As we have noted before:
The problem that arises all too often is that this approach is statistically bogus. The data gets cherry picked; backward-looking analysis gets form-fitted to what just happened and has no meaning for what is most likely to happen in the future. Confirmation bias and selective perception can lead an investor to lose objectivity, choosing an approach that justifies an existing portfolio mix, as opposed to objectively evaluating the data.
All of which leads me to the recent chatter about the Death Cross, which happened in yesterday’s trading. This takes place when a short-term moving average crosses a longer-term moving average — the 50-day and 200-day averages are standard, but it can be any combination of shorter- and longer-term averages. Note that some technical analysts have refined this to distinguish between crosses of a rising or falling moving average. See the following chart:
Among the major indexes, the Dow Jones Industrial Average has been a laggard, especially when compared with the Standard & Poor’s 500 or the Nasdaq Composite Index. Perhaps it’s a function of the Dow consisting of just 30 companies, a sampling that may be too small to be representative of the broader market. Maybe it’s the strengthening U.S. dollar hurting the big multinational corporations. Whatever the reason, yesterday’s decline triggered the dreaded Death Cross, as the index’s 50-day moving average crossed below the 200-day moving average. The other major indexes haven’t yet succumbed to the Death Cross horror, though the S&P 500 is heading in that direction.
In a research note late yesterday, Bespoke Investment Group observed that this was the first time this has happened since Dec. 30th, 2011, or in 903 trading days. They also note the modest statistical significance of the Death Cross. Looking at the past 100 years, they wrote that “the index has tended to bounce back more often than not.” Shorter term (one to three months), however, these crosses have been followed by modest declines in the index.
How modest? The average decline is 0.17 percent during the next month and 1.52 percent the next three months. By comparison, Bespoke notes, during the past 100 years the Dow averages a 0.62 percent gain during all one-month periods and a 1.82 percent rise during all three-month periods.
In an e-mail I asked Justin Walters of Bespoke to expand on the details. He wrote: “Most of the time these crosses don’t mean much of anything. This one the forward performance numbers are a little more negative than we would expect to see over the next one and three months, but it’s basically 50/50 whether we go higher or lower.”
Others who have looked at the historical trading data have reached similar conclusions. In July 2010, Bianco Research highlighted an earlier analysis by Ron Griess at TheChartStore.com of every instance of the Death Cross since 1930. The results were similar to what Bespoke found, if not even less statistically significant.
The bottom line: Although there are plenty of things for traders to worry about, the Death Cross this isn’t one of them.
Originally published as: Don’t Fear the Dow Death Cross as an Indicator
“Wall Street” always makes fun of technical indicators. This is because technical indicators are used by traders to define a condition of price over a time. All this does for the good trader is to outline a price parameter that is used to limit risk, with the understanding that it is being looked at by increasing numbers of people/traders and thus is relatively unreliable. But technical indicators like moving averages do tell of a change in momentum and possibly trend. That is all they say. That the price may be changing direction, with price being a sentiment indicator. Wall street is into money management. Technical indicators and money management can be done by any reasonably disciplined investor. Wall street makes their living by managing OPM. It is no wonder how they misrepresent technical trading and technical interpretation. It is all about how the picture is interpreted, taking into account as many influences on price as possible, and intuiting reason. (And then managing money to limit misfortune)