Death Cross? Hogwash

10/02/2014 9:00 am EST

Focus: STOCKS

Tyler Laundon

Editor, Cabot Small-Cap Confidential

There is no shortage of alarmist headlines in the major media outlets when the stock market gets volatile. And one focus of headlines has been the Russell 2000 "death cross," notes Tyler Laundon in 100% Letter.

The "death cross" happens when the index's 50-day moving average (MA) crosses below its 200-day MA. It's rumored to be a sign that the broad market is in trouble since small-caps, as a riskier asset, are often thought to be a leading indicator.

At least, that's the theory. But it's total hogwash. There is absolutely no reason for you to fear the Russell 2000 death cross. And, in fact, it's probably more likely that you should buy smal- caps when it happens, or at least, soon afterward.

I'm not saying that the event doesn't signal weakness in the market. Of course it does, that's the nature of a falling 50-day MA for the Russell. When it is going down, the index is going down.

But beyond that relatively obvious point, the crossing of the index's 50-day MA over the 200-day MA to the downside is a non-event.

Sentiment Trader has put together 30 years of data on the Russell 2000 death cross. Their data shows that the signal has occurred 26 times in the last 30 years.

Had you shorted the Russell 2000 each time the death cross occurred and left the trade on until the signal reversed (which took 97 days, on average), you would have lost money 81% of the time. Your average loss would have been 7%.

So forget about the Russell 2000 death cross. It doesn't mean anything, and it sure doesn't mean get out of small-cap stocks. In this 10-year chart, I've circled the last 7 Russell 2000 death crosses (the one that just occurred is circled with blue).

chart
Click to Enlarge

In four of the last six cases, investors would have been better buying small-cap stocks in the weeks after the death cross occurred to take advantage of the dip (what happens after the most recent occurrence remains to be seen).

Had they done so, then, on average, six months later, they'd have a gain of 6.7%. And this average includes the horrible returns in the six months after the 2007 and 2008 occurrences too.

In fact, going back over all 26 occurrences in the last 30 years shows that investors would have made money 69% of the time if they bought right after the death cross occurred and held for six months. The average return would have been 13.6%.

So forget about the Russell 2000 death cross. That is, unless you view it as a signal to buy small-caps in the following weeks. More often than not, that's a more profitable strategy then selling.

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