Steer Clear of the Death Cross

06/14/2011 10:00 am EST

Focus: STOCKS

Ian Wyatt

Publisher & Chief Investment Strategist, Wyatt Investment Research

It doesn't pay to jump on the hottest technical trends—newer doesn't necessarily mean better, says Ian Wyatt of Small Cap Investor.

I keep hearing about copper's potential "death cross" and the negative impact the cross would have on the market.

Really? Does copper truly have the predictive power that Wall Street analysts' are hyping? Or is the "death cross" in copper just another useless indicator, much like the Hindenburg Omen?

The so-called universally accepted theory suggests that if copper prices are declining, that means that demand is slow, the economy will suffer, and stocks will plummet.

Before writing this article I didn't have the answers, but after some diligent research I think I have a grasp as to how valuable the "death cross" is in predicting the next intermediate-term move for the market.

(A "death cross" is a technical indicator that occurs when the 50-day moving average crosses below the 200-day moving average. In theory, the crossover indicates a bear market is on the horizon.)

The Wall Street Journal recently reported a possible "death cross" in copper futures. Traders and analysts have been talking about the potential ramifications ever since. According to the article, a death cross would be a negative for copper and more importantly, the overall market.

I decided to back-test the "death cross" theory. I went back to 1989 (as far as my charting software would allow) and calculated the returns in the S&P 500 after each "death cross" signal in copper and the subsequent push back up through the 200-day MA.

There were 15 occurrences over this time frame, and according to the statistics the S&P 500 was positive 73% of the time (11 out of 15 occurrences) from when the 50-day MA moved below the 200-day MA (the point of the death cross), to when it crossed back above the 200-day MA.

The median return in the S&P 500 was 3.1 percent, with 73% of the occurrences ending with positive returns by the time copper's 50-day MA crossed back above the 200-day MA.

In short, the death cross pattern is wrong more often than right when used as an indicator of future performance for the S&P 500.

Following the signal would have kept you out of the sharp declines in 2001 and 2008, but it also would have kept you out of several large advances, including the 48.6% advance in 1997.

So the question remains, is the "death cross" in copper a good predictive indicator as to where the market is headed over the subsequent three months?

I would argue: no.

Too often, I see individual investors focus their energy on the latest and greatest predictive indicator in the news to make decisions on their long-term investment outlook.

There are all sorts of strategies that can work to make and preserve investment gains in small-cap stocks. But it's the one that investors stick to that will work over time.

Based on my research, I wouldn't stick to a strategy based on copper's death cross—unless I was going to get long the S&P 500.

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