/A 'Death Cross' Sounds Scary, But Is It?

A 'Death Cross' Sounds Scary, But Is It?

Over the last few days, there has been some talk about an ominous sounding technical chart pattern that has looked imminent for a while, and if the S&P 500 closes anywhere close to the levels indicated by futures this morning, will be achieved today.

This thing is known as a “death cross,” which, admittedly, sounds extremely scary. The dramatic name alone will probably be enough to ensure extensive coverage when the mark is hit, coverage that will probably cross over from financial to mainstream news and scare a lot of people.

In trading and investing, as in other areas of life, knowledge is the best weapon against fear, so now would be a good time to explain what a death cross actually is and why it may or may not prove significant.

As I’m sure you will be told many times over the next few days, a death cross is when a short-term moving average crosses over a longer-term one. That sounds simple enough, but that is part of the problem. Technical analysis often sounds simple, but rarely is.

Indeed, just the words “technical analysis” imply objectivity and finality, but nothing could be further from the truth. Almost all technical studies are subjective in some ways, and the conclusions from them are, by definition, speculative. They involve looking at the past and, from that, inferring the future, which is analogous to studying the form of racehorses.

It can be useful, and arguably beats random selection, but any conclusions reached are far from certain.

To understand a death cross, you must first understand a moving average (MA). A moving average is a value derived by averaging the closing price over a given number of time periods.

A 50-day moving average, for example, would be calculated by adding the last 50 closes and dividing that number by 50. When MAs are plotted on a chart, they serve the purpose of smoothing out short-term volatility, therefore better identifying, or more accurately confirming, trends.

When you plot moving averages over two different time periods on a chart you are identifying two trends, one long-term and one short-term. When the short-term line crosses over the long-term, in either direction, it logically indicates that the short-term momentum is powerful enough to alter the long-term trend.

Thus, when the short moves above the long it signals strong upward momentum and when it moves below, downward. The former is known as a golden cross, the latter a death cross. Both are considered strong signals, bullish in the case of a golden cross and bearish for a death cross.

Figure 1: S&P 500 Futures ES. The death cross appears today, when the 50 Day MA (blue) crosses over the 200 day (yellow)

There are, however, a couple of provisos. First, where the crosses appear obviously depends on what time period you use, and over how many closes. That is not set in stone, but for longer-term analysis most people use 50 and 200-day averages, so let’s stick to that for now. In addition, technical analysis only works if people pay attention.

What moves price is the relative motivation of buyers and sellers, not lines on a chart. Technical “signals” are only signals if they prompt people to buy or sell.

Both Death and Golden crosses are widely watched, particularly as they become a trendy topic, so there should be enough people paying attention to make this crossover significant.

Given that, it sounds as if in this case the ominous-sounding name is justified, but there are several redeeming factors.

As I said, there have been rumbling about the approach of the death cross for several days. That makes it likely that many traders have already sold in anticipation of the signal, creating positions that will be closed after the averages cross. That creates support just below the actual level and makes a collapse less likely.

More importantly, like all technical-driven moves, a selloff prompted by a death cross is short-term in nature and will always be superseded by any change in fundamental conditions.

If the Fed were to say that they have decided not to hike rates this month, for example, or if Donald Trump were to announce a comprehensive, beneficial trade deal with China tomorrow, stocks would reverse direction rapidly. I am not saying that either of these things will happen, but if you imagine the reaction if they did, you understand why technical signals can so often be misleading.

In fact, they can be so even without big news. MA crossovers, like any technical event, send a lot of false signals and are a long way from certain to result in the expected move. One recent example is in oil futures. As you can see here below, the death cross was reached a couple of weeks ago on the chart, but far from it triggering a massive selloff, it has so far marked the base of the move.

Still, to some extent, widely-watched signals such as this are self-fulfilling prophecies. If enough people believe that a death cross precedes a big drop and sell as a result, the big drop will come. That makes further volatility likely over the next few days, but ultimately it is the state of the economy and the level of corporate profitability that drive stock prices, not lines on a chart.

The current bearish trend suggests that the best guess of traders and investors is that economic conditions are about to decline, dragging profits down. The key word here is “guess.”

It is an educated guess for sure, but until the data support it, it is still a guess. As scary as a death cross sounds therefore, long-term investors should not pay it too much attention, and should remain focused on conditions rather than charts.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.