A Death Cross Isn’t Always Scary

An article recently appeared on MarketWatch bearing the title “Dow death cross is a bearish omen for the stock market.” Does this mean it’s time to panic? Should I run for the hills right now? Should I get a preacher to exorcise the demons that are causing this supposed Dow omen?

Referring to the death cross as an omen can be misleading. The dictionary says that an omen is a portent. It’s prophetic, it’s a prediction. Omens are thought to be a forewarning or danger sign.

That has too much of a crystal ball feel to me.

Let’s look at what a death cross really is and what it could mean for the market.

We find death crosses by looking at moving averages of the stock market. They can be helpful in predicting potential falls in the market, but they are definitely not a perfect prediction of what is to come.

What is a moving average?

Let’s think about a moving average in terms of a teacher giving grades to his students. Instead of taking an average of all of his student’s test scores, the teacher decides to use a moving average to determine the overall grade. If the teacher decides to do a 4 grade moving average, it means that he will take the average of the 4 most recent grades to determine the overall grade.

For example, if a student has taken 6 tests, the teacher drops the first two grades and takes the average of the last 4. Let’s say the student has 5 A’s in a row, then drops to an F. With the moving average, the teacher will only use 3 A’s and 1 F. The student’s average grade would drop very quickly because the teacher isn’t taking into account all of the grades – he’s only looking at the most recent.

Moving averages work the same way in the stock market. When the stock market is doing well, we can say that it’s receiving an A grade. It might perform well for a time, getting a series of A grades, then it might drop suddenly. The sudden drop lowers the overall moving average.

Doom and gloom

When using moving averages to look at the market, you want to look at two different lines measuring the average of differing increments of time. Generally, the two moving average lines are for the last 200 days and 50 days. We look at these two moving averages simultaneously to eliminate what is called whipsaw. Whipsawing is where the prices are whipsawing above and below the average line.

Sometimes the two moving average lines cross over each other. A death cross occurs when the 50 day moving average drops below the 200 day average lines.

The author of the MarketWatch article says that the recent death cross is an omen of bearishness. They say that the death cross predicts that the market is dropping dramatically. This isn’t necessarily the case. When you see a death cross, it doesn’t mean that you must panic and get out of the market. It’s not a crystal ball and it’s not an omen. Just because I have a death cross in 2014 doesn’t mean that the whole thing is going to tank.

If you look at the Dow Jones industrial average, August 13th doest note a death cross. However, there was also another death cross in 2011 and another in 2010. Neither of those death crosses led to a terrible drop in the market.

While death crosses help to catch our attention, it doesn’t always mean that the market is going to tank. When using moving averages, it’s important to compare several different indices. For example, if we compare the Dow Jones and the Russell 2000, we’ll see that the Russell 2000 has death crosses all over the place, especially recently. But you’ll notice that the death crosses are closely followed by a golden cross. The NASDAQ has not shown a death or golden cross for a long time.

The death crosses might simply indicate a bigger gyration than normal. There are many occasions where a gold cross follows shortly after a death cross. The headline in MarketWatch is misleading because we could have a headline tomorrow if the moving average lines cross again saying “Golden cross is a bullish omen for the stock market!”

The death cross doesn’t necessarily mean the market is doomed. Certainly, there have been some nasty ones in the past, so it’s important to recognize the death crosses so that we can be alerted to watch the market carefully and make decisions accordingly.