5 Reasons Why Not to Overreact to the Death Cross
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The death cross sounds so dramatic. The death cross is when a short-term moving average crosses to the downside through a long-term moving average. The most commonly used moving averages when assessing a death cross are the 50-day moving average and the 200-day moving average.
After reading the above paragraph, that's pretty much all you will find on the web. In this article we are going to take it a step further and provide you 5 reasons of why you should not panic when a death cross occurs.
#1 The Death Cross is really just a guidepost
When you think about the death cross, it's really just a way of identifying when a long-term trend is in jeopardy, because the short-term average is trending harshly to the negative side.
Now, if you are a 5-minute or 15-minute trader why do you care? I would dare to say no.
This is where people get caught up in the title of 'death cross'. It sounds like something we all should be terrified of and just run to the hills. While it makes for a great storyline on CNBC after the market has had a long bull run, to us traders, it's really just noise depending on the timeframe you trade.
Now, if you are a swing trader or long-term investor, definitely take pause when a death cross occurs. When I say pause, this doesn't mean panic; look for additional clues of where the stock will go. For example, is the stock hitting a previous support area or going back into a congestion zone?
Again, a death cross is not a reason to pack it in, but more of a time to assess your trade and the future profit potential.
#2 Everyone knows about the death cross
A general trading rule is that the more people know about something, the less likely it will occur. So, where is your trading edge when using the death cross? How are you using information that isn't readily available to other traders to make your decision?
When I think about the death cross and trading, it's less to do with me making a decision based on the death cross and it's more about watching how other traders react to the technicals.
If everyone begins to panic sell, I will sit tight and wait for the weak longs to exit. If the death cross occurs in conjunction with the break of a major support level, I will likely exit the position on the next bounce. Not because of the death cross, but because of a breach of support.
#3 The Death Cross is a lagging indicator
The death cross is based on moving averages. By default, moving averages are lagging because they are based on a pre-defined look back period. Death crosses have even more of a lag, because it is looking back 50 and 200 day periods. This translates into almost 3 months of trading for the short-term average and approximately 40 weeks for the long-term average.
Think about that for a second. These are some pretty long look back periods. If you are trading a volatile stock, a whole lot can happen in the next 3 to 9 months. With this much of a lag, there is the possibility that other traders have already priced in the fear and you could be showing up late to the party with your short trade.
#4 The traders of your stock may not care much about the death cross
Every stock has a controlling interest at any given point in time. There are some investors that exclusively trade certain securities and the stock moves in a repeatable fashion. This controlling interest may trade the stock based on the slow stochastics or they may trade based on fundamentals. Or the controlling interest may be trading the stock as a hedge for another position in their portfolio.
The point I'm trying to get across is there are so many factors that could play into what the controlling interest of your stock could be monitoring at any given time. So, why get wrapped up into the fact there was a death cross?
#5 Death Crosses don't mean much when it comes to the broad market
Now that we have in theory drained the concept that death crosses aren't really anything to worry about, let's now focus on the actual data. I'm going to look back at the last 5 death crosses on the iShares Russell 2000 Index Fund ETF (IWM) and where the ETF was trading 1 year after the death cross.
Death Cross #1 - August 12th, 2011
Since the market has been in a strong uptrend over the last few years, the last death cross for IWM was on August 12th, 2011. The IWM on that day closed at $69.79. Fast forward one year and on August 13th, 2012 (12th was the weekend), IWM closed at $79.79. This represents a gain of 14.4%.
Death Cross #2 - July 28th, 2010
IWM on July 28th, 2010 closed at $65.15. Fast forward one year and on July 28th, 2011 IWM closed at $79.84. This represents a gain of 22.5%.
Death Cross #3 - October 8th, 2008
This death cross was exceptional because it was in the thick of the mortgage crisis. On that day, IWM closed at $54.46 on October 8th, 2008. Now, please jump in my time machine and fast forward to October 9th, 2009 and you will see IWM closed at $61.42. This represents a gain of 12.7% one year after the death crosses of all death crosses during the mortgage crisis.
Death Cross #4 - September 7th, 2007
IWM on September 7th, 2007 closed at $77.66. Fast forward one year and on September 5th, 2008 (7th was Labor Day), IWM closed at $71.64. This represents a loss of 7.8%. This is the first loss we've encountered through this analysis, but I wouldn't use words like "death" in the same sentence with a 7% loss.
Death Cross #5 - July 21st, 2006
On July 21st 2006, IWM closed at $66.75. Fast forward to July 20th, 2007 (21st was the weekend), IWM closed at $83.20. This represents a gain of 24.6% one year after the death cross.
Let's try look at the data in a summary table view.
|#||Date of IWM Death Cross||Death Cross Closing Value||IWM Closing Price One Year after Death Cross||% gain or (loss)|
So, after all the numbers have been tallied, there is an average return of 13.28% for the IWM over the last 8 years. Out of the 5 death cross occurrences, only 1 was negative and the other 4 provided double digit gains.
This analysis goes back the last 8 years in the market. Now, if we were to go back 10 or even 20 years, the results may not be as positive, but is there any reason to run for the hills if you are a long term investor? Call me crazy but the death cross could actually be used as a contrarian technique for trading the markets.