Stocks: Hold Until Death Do Us Cross?

Includes: DIA, IWM, QQQ, SPY
by: Eric Parnell, CFA


The Death Cross is considered an ominous event for stock investors.

Whether the Death Cross is actually as threatening as it sounds merits closer examination.

The efficacy of the Death Cross as a market signaling tool yields some surprising results.

The Death Cross is an investment market event that simply by its name might send chills through the spine of the average stock investor. It takes place when the average closing price of the U.S. stock market over the last 50 days falls below the average closing price over the last 200 days. Such a crossover between these two readings is widely considered a bearish signal that stocks are poised to plunge much lower. As a result, many investors are inclined to use the Death Cross as a signal that the time has come to lighten up on stock positions and move to the sidelines to protect against portfolio losses. But despite its ominous-sounding name, a closer examination is worthwhile to determine whether waiting for a Death Cross is truly an effective strategy from a risk-protection standpoint.

The History Of The Death Cross

The Death Cross is a fairly uncommon occurrence for the U.S. stock market. Over the last 85 years, stocks, as measured by the S&P 500 Index (NYSEARCA:SPY), have experienced a Death Cross on 44 separate occasions. The last such instance took place in 2011, which is shown in the chart below.

So why would some investors be monitoring risk indicators like the Death Cross in today's market? After all, U.S. stocks are nowhere close to such an event at the present time, as shown in the chart below, as they are instead in a sustained uptrend. The reason for concern among some investors is that the current bull market in stocks at over five years is already longer than the historical average. And in an environment where economic growth remains sluggish, corporate fundamentals have become lackluster, valuations are arguably rich and the U.S. Federal Reserve is in the process of unwinding its massive QE3 stimulus program, the potential exists for the stock market to enter into at least some sort of sustained correction at some point going forward. As a result, many stock investors are on the lookout for any advance warning readings that can reliably signal that the time has come to head to the exits.

Where Is The 'Death' In Death Cross?

As for the Death Cross, an examination of stock market performance in and around these supposedly bearish crossovers is notable indeed, for several reasons.

First, a fair amount of portfolio damage has already been sustained by the time the Death Cross takes place. For example, this bearish crossover has historically occurred 74 days on average following a market peak, for an average decline of -10.66%. In short, your stock portfolio is likely already down by double-digits before this alert is signaled.

Still, this indicator might be considered worthwhile if protection against meaningful further downside is provided. Exploring this point in more detail, stocks have continued lower for another 77 days on average after a Death Cross, before bottoming with an average decline of another -12.21%. Thus, one might conclude, at first glance, that reacting to a Death Cross might at least provide protection against roughly half of a total stock market pullback. But a closer dissection of the numbers reveals that such "halfway" portfolio protection is typically not the case.

In many instances, the stock market is either at or near a bottom by the time a Death Cross has taken place. For example, of the 44 past Death Crosses in the last 85 years, the stock market has literally bottomed on the day that this bearish crossover has taken place in 8 instances. In other words, in 8 out of 44 Death Crosses, or 18% of the time, an investor using this bearish crossover as an exit signal would have had them selling at exact bottom of the market. Hardly a positive outcome to have take place nearly one out of every five times.

This bottom-ticking percentage is bad enough, but it gets even worse upon further inspection. In another 12 of the 44 past Death Crosses, or 27%, the stock market bottomed within 10 trading days after the bearish crossover occurred. And 4 more, or another 9%, bottomed within 25 trading days, or roughly a month after the Death Cross took place. In summary, the Death Cross has effectively served not as a bearish reading, but to the total contrary, an effective bottom-ticking signal more than half the time. For an example of how such an event could play out this way, please refer back to the 2011 chart above.

So the Death Cross misses the mark badly more than half the time, but what about the other half? The evidence here is also not very compelling. In only 14 out of the 44 past Death Crosses did the stock market go down further by more than -10%. Put differently, the stock market declined by less than -10% following 30 of the 44 past bearish crossovers, which is hardly a reason to evacuate the stock market. Taking this further, stocks went on to fall by more than -20% in just 9 past instances. While a stock investor certainly wishes to avoid such major market corrections, an indicator like the Death Cross, with a roughly 20% success rate is poor, particularly when this same reading instead effectively signals a market bottom three times more frequently.

So How Exactly Can The Death Cross Be Useful?

Despite these shortcomings, information related to the Death Cross does provide some useful leading signals for investors seeking to protect against the next market correction.

First, while the actual crossover of the 50-day moving average below the 200-day moving average comes far too late in most instances, the spread between the 50-day and 200-day moving average can serve as a useful leading indicator that the stock market may soon be poised to fade into at least a short-term correction. For example, a 50-day moving average reading that is more than 10% above the 200-day moving average has historically been unsustainable for extended periods of time, and may help signal that a near-term market peak may be imminent. And while readings above 5% can be sustained for a period of time, perhaps a year or more, such spreads are also fairly uncommon. Putting the current market into perspective, this spread has been running in excess of 5% since February 2013, and at 5.01% today, is a few percentage points removed from the peak readings from July 2013 toward the 8% range. Such readings do not necessarily imply that a correction will soon follow, however, as a period of consolidation might take place instead.

Another application is the passage of time between Death Crosses. While most such crossovers have proven largely benign, a select few have been followed by major market corrections. And each of these 9 damaging instances has occurred following what has been a longer-than-normal period between Death Crosses. In other words, when the market goes 500 trading days or more between Death Crosses, the historical probability for a decline following such a crossover in excess of -20% jumps to roughly one-half of the time. Given the fact that it has been 657 trading days now since the last stock market Death Cross in 2011, the current market is now operating in this higher-risk zone.

Bottom Line

While the Death Cross sounds like a dreadful event for the U.S. stock market, it is hardly anything that should be considered resoundingly bearish. Instead, it is a lagging indicator that comes far too late to provide investors with any meaningful portfolio protection. In fact, it is arguably more effective as a leading market reversal indicator than it is a bearish indicator. It does have some uses in limited applications, but for investors seeking a reliable leading indicator to help protect their portfolios against any future stock market decline, they are likely best served to look elsewhere. Repeated breaks of the 200-day moving average is just one of many alternative examples.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long the stock market via the SPLV and XLU, as well as selected individual stocks. I also have a meaningful allocation to cash.

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