Golden Crosses: The Bible

Traders and financial commentators frequently refer to the “golden cross” and “death cross” patterns seen on price charts. For example:

• July 1, 2010: S&P in Grips Of Death Cross?
• August 31, 2011: ‘Dead Cross’ Triggered—Look Out Below Large Caps
• January 13, 2012: Golden Cross Forming?
• January 31, 2012: Stocks Form ‘Golden Cross’ With Today’s Market Close
• January 31, 2012: Jim Cramer Off the Charts: ‘Golden Cross’

The golden cross and the death cross

The “cross” refers to two simple moving averages “crossing” over each other. A golden cross is considered a bullish sign; it occurs when the 50-day moving average rises above 200-day moving average. A death cross is considered a bearish sign; it occurs when the 50-day moving average drops below 200-day moving average.

An early mention of moving average crossovers is found in the 1935 book, Profits in the Stock Market, by H. M. Gartley:

“One of the most useful technical phenomena in the determination of major reversals is the major trend moving average. For this purpose, the author prefers to use a 200-day moving aveage, although equally satisfactory results can also be obtained with the use of a 20-30 week moving average applied to weekly charts, or a 4-6 month moving average applied to monthly charts.”

Since then, technicians have popularized the use of various moving averages. During the 1970s, Stan Weinstein’s Secrets for Profiting in Bull and Bear Markets was a big seller. He wrote,

“All that a moving average really does is smooth out the major trend so the wild day-to-day gyrations –which the new buying and selling programs have made even wilder–do not throw off your market perspective. Over the years, I’ve found that a 30-week moving average (MA) is the best one for long-term investors, while the 10-week MA is best for traders to use.

Stage analysis used the price relative to the moving average to identify four stages of a price cycle.”

John Murphy, the famous CNBC analyst from the 1990s, wrote in The Visual Investor,

“Two moving averages are commonly used to analyze market trends. How the two averages related to each other tells a lot about the stength or weakness of a trend. Two commonly employed numbers among stock investors are the 50-day (10-week) and the 200-day (40-week) combination. The trend is considered bullihs (upwards) as long as the shorter average is above the longer. Any crossing by the shorter average below the longer is considered negative. Some analysts use a 10-week and a 30-week average for the same purpose.”

The use of moving averages became so common that they are mentioned in the McGraw-Hill Investor’s Desk Reference.

Is the “cross” a reliable signal?

How effective are moving average crossovers as technical trading rules? Three landmark academic papers tell the tale.

In 1991 — Simple Technical Trading Rules And The Stochastic Properties Of Stock Returns — researchers Brock, Lakonishok and LeBaron tested “two of the simplest and most popular trading rules–moving average and trading range break–by utilizing the Dow Jones Index from 1897 to 1986″ and found “strong support for the technical strategies”.

In 1999 — The Stability of Moving Average Technical Trading Rules on the Dow Jones Index — LeBaron revisited the study with one more decade of data. The findings were disturbing enough for him to ask, “Has something about the dynamics of stock prices changed over the past 10 years, or was the original trend following strategy mined out of the previous 90 years of data?”

LeBaron further noted that Sullivan, Timmerman & White (1999) — Data-Snooping, Technical Trading Rule Performance, and the Bootstrap — “demonstrated that while it appears unlikely that these rules were “snooped” from the earlier sample, their forecasting performance over recent years has disappeared.”

We would like to offer two possible explanations of why the crosses appear to “work” less than they used to.

1. It could be that proliferation of personal computers has made price charts and moving averages ubiquitous, and therefore, eroded the potential edge it once conferred.
2. Moving averages are “smoothing” techniques designed for detrended data in time series analysis; therefore, indicators based on the difference between the price and moving average may be more effective than a crossover.

The Edwards, Magee and Bassetti edition of Technical Analysis of Stock Trends summed it up nicely, “The 200-day moving average is widely believed to be the long-term trend indicator, and believing will sometimes make it come true.”

We at TradeWithPete.com use the golden and death crosses as filters to help narrow the field of ticker symbols for further sentiment and price action analysis.

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