Don’t fear Dow death cross

One of the themes we like to touch on in this column are heuristics. Myths that become Wall Street rules of thumb have existed for as long as there have been trading desks. They pop up regularly and most of the time they are terribly wrong.

Many of these trading myths now come with what looks like the imprimatur of quantitative analysis. But as British Prime Minister Benjamin Disraeli is reputed to have said, “There are three kinds of lies: lies, damned lies, and statistics.”

The problem that arises all too often happens when data gets cherry picked. Backward-looking analysis gets form-fitted to what just happened and has no meaning for what is most likely to happen in the future. Confirmation bias and selective perception can lead an investor to lose objectivity, choosing an existing portfolio mix, as opposed to objectively evaluating the data.

All of which leads me to the recent chatter about the Death Cross, which happened one day last week. This takes place when a short-term moving average crosses a longer-term moving average – the 50-day and 200-day averages are standard, but it can be any combination of shorter- and longer-term averages.

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Among the major indexes, the Dow Jones Industrial Average has been a laggard, especially when compared with the Standard & Poor’s 500 or the Nasdaq Composite Index. Whatever the reason, last week’s decline triggered the dreaded Death Cross, as on Tuesday the index’s 50-day moving average crossed below the 200-day moving average.

In a research note, Bespoke Investment Group observed that this was the first time this has happened since Dec. 30, 2011, or in 903 trading days. They also note the modest statistical significance of the Death Cross. Looking at the past 100 years, they wrote that “the index has tended to bounce back more often than not.” Shorter term (one to three months), however, these crosses have been followed by modest declines in the index.

How modest? The average decline is 0.17 percent during the next month and 1.52 percent the next three months. By comparison, Bespoke notes, during the past 100 years the Dow averages a 0.62 percent gain during all one-month periods and a 1.82 percent rise during all three-month periods. 

The bottom line: Although there are plenty of things for traders to worry about, the Death Cross isn’t one of them. n

Barry Ritholtz is a Bloomberg View columnist.

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