Thursday, August 25, 2011

Debunking the Death Cross Chart Pattern


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One of the better-known technical indicators was triggered in July last year and you probably heard about it somewhere. When the 50-day simple moving average of the S&P 500 cash index crosses below the 200-day simple moving average of the same index, market pundits call this the Death Cross or Black Cross signal. Here’s what that looked like 13 months ago.


The most interesting thing about this signal was the amount of interest it generated last July: talking heads on TV, pundits throughout the media and every Tom, Dick or Jane who had a blog seemed to be blathering on about the Death Cross. To be fair, we had been in a two and a half month drop in index prices, and market sentiment was extremely negative. Aside from all of this, however, there was still an inordinately high level of interest in the Death Cross last year.

Did you know another Death Cross happened this past August 12th? Maybe not—there was much less fanfare about it this time. I still heard it bantered about in the technical analysis outlets, but the broader press barely mentioned it. Why?

The reason for the more subdued reception of Friday’s signal is simple: the Death Cross last year didn’t work. The implications of this drastically different reaction for all traders and investors are important, and today, we’ll focus on the psychology behind it.

The Last Event Bias

You have to forgive the pundits for all of the fanfare they gave the Death Cross in July 2010—they readily remembered the last time it triggered in December 2007. The Death Cross that preceded the market collapse of 2008 was excellent in its timing, and those who got into cash or shorted the market based on the signal were richly rewarded. Let’s look at how the 2008 Death Cross worked out.


In stark contrast, the Death Cross from July 2010 didn’t work at all. So on Friday if some technical analysis geek had told the newsroom producer that a Death Cross has just triggered, he or she probably would have said, “Show me the last one.” This chart is what they would have seen.


Looking for something newsworthy, the producer would have said instantly, “Didn’t work. Not interesting.”

Even though our rational thought process tells us to evaluate how something worked over many trials, traders often fall into this same powerful psychological trap: “It didn’t work last time.”

To understand why we fall into this trap, let’s review the peak-end rule popularized by Nobel laureate Daniel Kahneman. We talked about Kahneman’s work extensively in an article series after the Flash Crash in 2010, so I’ll just summarize here:

Kahneman and his colleagues found that people remember and quantify past experiences (whether pleasing or painful) based only on two points: the peak level and the last or end event.

This means that we base decisions on emotional recollections that are either the extreme or the most recent, not an average for all of them.

Kahneman makes it easier for us to understand that last July’s Death Cross had a lot of attention because the previous occurrence had been so massively successful. The psychological effect of the peak-end rule made people very curious as to what would happen, so it was big news.

The market went on to move more than 20% to the upside, however, after last July’s Death Cross. Since folks remember that the last one didn’t’ work, the recent bias caused few news outlets to run the Death Cross story this past Friday when it triggered.

Great Trading, D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. the International Institute of Trading Mastery.