All Death Crosses Are Not the Same

09/25/2014 6:00 am EST

Focus: STRATEGIES

Gregory Harmon, CMT

Founder and President, Dragonfly Capital Management

Technician Greg Harmon of Dragonfly Capital explains how “Death Crosses” aren’t very interesting as trading signals but can provide value as long-term indicators, if you know what to look for.

The Death Cross in the Russell 2000 seems to be all that anyone talking about. Mostly because it sounds cool, I guess. So are you sick of it yet? Death Crosses—as trading signals—are not very interesting. They lag the price action and often you will have already seen the bottom before the Death Cross occurs. But as a long-term indicator they can carry some value, if you know what to look for. You see, all Death Crosses are not created equal.

The Death Cross is defined as when the 50-day Simple Moving Average (SMA) crosses down through the 200-day moving average. It seems simple enough to interpret. If the shorter moving average is falling through the longer moving average the price is falling and the short-term momentum is to the downside. Plenty have discussed the statistics of how the market does three, six, or 12 months after one so I won’t repeat that here (spoiler: it is higher). But what happens in three, six, or 12 months without looking at what happens in between is ludicrous for a swing or position trader. Even a position trader may not be able to stomach the short-term pullback, and I am sure those talking statistics are not holding stop losses that allow for a 25% decline along the way. So what can you do? Lets look at the last four Death Crosses in the Russell 2000 ETF (IWM) a bit more closely to see if there are some clues.

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The chart above has the last four Death Crosses marked, as well as the one happening now. You can see that in all four cases, the market had fallen by at least 7% and as much as 20% before the Death Cross. This reinforces the point that a Death Cross is a lagging signal. But also in three of the four, the IWM headed lower by over 10%, following the Death Cross, before a Golden Cross changed the signal. The fourth time, in 2010, the move following the Death Cross was muted. What is the difference?

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The one major difference in the 2010 Death Cross was the angle when the two moving averages crossed. The angle was very steep in 2007, 2008, and 2011. But look at it in 2010. They are both nearly flat. This makes sense if you think about what would make one moving average change direction sharply, creating a bigger angle. A burst of momentum to the downside or start of a trend lower after a long flat or rising period would do it. The cross in 2010 happened in a slow move lower after a slow rise, a glancing cross. And the glancing blow did little harm. This is important because it is exactly how the current Death Cross has happened. A near glancing cut lower by the 50-day SMA. If it reverses this week, many will miss that is was a cross when looking at this chart in the future. This current Death Cross does not seem to be a big signal of a major move lower. There is no strong momentum to the downside. The IWM has been moving sideways for 11 months. That is not to say a major move will not happen. But I would not be taking off my IWM related positions because of this signal.

By Greg Harmon of Dragonfly Capital

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