Investors should ignore market's 'golden cross' signal

SERIOUS MONEY:THE SHARP UPTURN in stock prices since the start of the year has taken most investment professionals by surprise. Indeed, consensus opinion contained in the lengthy annual investment tomes released by brokerage houses just weeks ago, predicted that the major stock market indices would remain volatile and tread water into the summer.

This was because concerns over the state of the global economy alongside the seemingly never-ending crisis in the euro zone was expected to keep investors’ natural bullish appetite in check.

Further, gains of the magnitude enjoyed during the opening weeks of 2012 were not envisaged until the second half of the year, by which time it was contended that the large concerns weighing on market sentiment would have diminished, as if by magic.

Needless to say, the notion that directional changes in stock prices can be anticipated with such precision is decidedly naive, yet Wall Street strategists continue to engage in this fruitless pursuit year after year regardless.

However, just as the upturn in equity prices has left bewildered strategists with egg on their faces, the stock market’s behaviour has presented technical analysts – the students of historical price patterns – with the opportunity to step forward and salivate over a supposedly bullish market development, a “golden cross”.

A golden cross is said to occur when the stock market’s 50-day moving average of closing prices rises above its 200-day moving average and is considered by technical analysts to be a portent of future price strength. In absence of a major market setback, the S&P 500 should register the alleged bullish signal to much fanfare by the time this column is published. But is the golden cross really worthy for inclusion as an input that helps guide tactical positioning?

There have been 43 golden crosses since January 1928, and the signal has been followed by 12-month returns of more than 9 per cent on average or two percentage points above the long-term mean.

The signal has delivered positive 12-month returns on 32 occasions or almost three-quarters of the time and has been followed by above-average returns over the subsequent year on 23 occasions or more than half the time.

The historical record appears to suggest that the so-called golden cross does deliver respectable returns on an annual horizon, though the incidence of above-average returns is not much better than a coin-toss, while the frequency of loss – at more than one in four – is not significantly below long-term experience.

More importantly, the strength of the signal appears to depend on whether it is associated with a recession-induced decline or not. There have been 15 signals through the past eight decades that were registered as equity prices were recovering from a recession-induced bear market. The average 12-month return subsequently recorded has been an impressive 19 per cent or 12 percentage points above the long-term mean.

Further, a recession-recovery signal has been followed by above-average 12-month returns on 13 occasions or more than 85 per cent of the time and has resulted in negative returns just once way back in 1938. Thus, the historical record confirms that the “buy” signal heralded by the golden cross is worth heeding when it is associated with a recession-induced stock market decline.

But can the same be said for the remaining 28 non-recession signals? The answer would appear to be no.

Of the 28 non-recession golden crosses, only 10 or little more than one-third were followed by above-average 12-month returns and, a further 10 signals saw negative returns over the subsequent year – an incidence of 12-month loss that is higher than the historical stock market record.

The erratic performance of the non-recession signals is such that the returns subsequently delivered lag the stock market’s historical mean return over any short-term period worthy of note, including three-, six-, nine- and 12-month horizons. On an annualised basis, the signal’s performance lagged returns that could have been generated by chance over the respective short horizons by three to four percentage points.

In a nutshell, golden crosses that are not associated with an economic downturn do not work and have no place in the toolbox of seasoned investors.

Unfortunately, human beings are hardwired to detect patterns and associations – even when none exist – in an effort to find order amid the endless chaos. This evolutionary quirk allows investment strategists and technical analysts to issue precise short-term forecasts that satisfy our hunger for order and placate our natural optimism.

The bullish signal emitted by the non-recessionary golden cross is a classic example of such nonsense and, investors who act on such misguided advice should know that in evolutionary terms, they are behaving little differently than a moth who chases a flame.

[ charliefell.com ]