Friday, July 2, 2010

Death Cross: Fact and Fiction

Much is being made of the "Death Cross", when an index's 50 day moving average crosses below its 200 day moving average. Those making the most noise on this topic use the simple moving average (e.g. 50 days divided evenly) as opposed to the exponential (e.g. 50 days weighted more toward the most recent days). Therefore, it is worth taking a moment to observe the two versions and how one (the simple) tends to produce false signals than the other (the exponential).

In the recent 2002 to 2008 bull market in stocks, the accompanying top two charts* illustrate how the simple version (on the right) can produce false signals (2, to be exact), whereas the exponential (on the left) did not.

In the current market decline, the simple (on the right) will almost certainly generate a "Death Cross" whereas the exponential (on the left) may or may not.

Not The Only Tool In the Toolbox

It is also important to remember that the moving averages are one of several very useful technical analysis tools that should be relied on, particularly when attempting to forecast major market turns. Since we currently have other important indicators, such as non confirmation divergences (see previous post below) from other indices, it is premature to call the end of the current bull market solely based on one indicator.

(For the record, I use the exponential. Also for the record, I do believe the odds favor a bear market will eventually emerge. However, until I get signals from all indicators followed I cannot make that call. This may cause me to be late to the bear game. However, I would rather be late to a game changer than premature and get whipsawed. Moreover, the prospect of a bounce back rally this summer and how to play it (to gain absolute and relative performance) is enhanced.)

*click images to enlarge

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