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Death Cross Sounds a Lot Scarier Than It Is

Death Cross Sounds a Lot Scarier Than It Is

April 27, 2023

Few, if any, technical analysis patterns have a more ominous name than the “death cross.” This pattern is simply when the 50-day moving average (dma) for a security or index crosses below the 200-dma. While you could look at any market decline and find this cross at some point prior to it, you might be surprised by the results when we look back at these crosses and analyze the performance that followed.

The small cap Russell 2000 Index triggered a so-called death cross on April 21 after the 50-dma had been above the 200-dma for the past 3 months (the opposite cross is called a golden cross, last triggered on January 25, 2023). The Russell 2000 Index has struggled to gain technical traction over the last month after being weighed down by its regional bank exposure following the Silicon Valley Bank failure. A downtrend subsequently emerged off the February highs, further validated by the death cross, as shown in the accompanying chart.

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While the name death cross sounds ominous, history shows investors tend to experience more losses before they occur than after. That means this technical signal tends to not work very well for traders who follow it. As shown in the next chart below, performance for small cap stocks has been much better after death crosses than before them.

Once the death cross has occurred, more often than not stocks tend to bounce. We’re not calling for an immediate rebound in small caps by any means, but this data certainly suggests the odds are good the Russell 2000 will be higher six and 12 months out.

As shown in the chart, it takes a modest pullback typically of about 5% within three months for this chart pattern to occur. Once it does, small caps tend to struggle for a month or so before recouping those losses in subsequent months. The median gain of 8.9% six months after a death cross is particularly bullish.

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This doesn’t mean this chart pattern should be ignored. If it is the start of a reversal and a new long-term trend, the signal can be effective. Moving average crosses can confirm trend changes even if they are unreliable trading signals based on historical data.

You don’t have to go back very far to find an example of how this pattern can be helpful. On January 19, 2022, the Russell 2000’s death cross was followed by a 12.7% decline over the rest of the year. While caution may be warranted in the short term (LPL Research downgraded its small cap view to neutral in early April and the overall technical picture is negative), we do not expect this trigger to be followed by a sustained downtrend for small caps over many months.

Why not? First, we don’t expect the economic environment or credit conditions to deteriorate enough to drive a significant and lasting decline. If we get a mild, short-lived recession, as we expect, market participants may look through to the other side of this downturn, which could help mitigate the magnitude and duration of any decline. Lower inflation, the likely prompt end of the Federal Reserve’s rate hiking campaign, and attractive valuations may also help limit any small cap slide.

What about large caps?

You might be wondering where the moving averages are for large caps. The S&P 500 Index has not entered a death cross yet, but may soon because it’s getting close. The large cap index executed a golden cross pattern on February 2, 2023, and has fallen 2.6% since then (an example of the opposite chart pattern not being bullish as one might expect). At 4,071, the index’s 50-dma (4,035) is only 1.9% above its 200-dma (3,960).

 

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

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All index and market data from Bloomberg.

This Research material was prepared by LPL Financial, LLC.

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