Uh-Oh! A Death Cross   

In case you haven’t heard “US Small cap stocks just formed a death cross”. Eee gads. Kinda grabs your attention as it sounds ominous, doesn’t it? The name conjures up thoughts of October 1929.  In technical analysis jargon a death cross is nothing more than when the 50-day moving average crosses under the 200-day average.  Those trying to grab your attention in order to sell advertising just love names like death cross. Fear pays. Another one that comes to mind is the Hindenburg omen.  Sell everything, run for cover and get into your bomb shelter we have had a number of recent Hindenburg sightings of late.  There are, of course, others but I digress.

Why make news of the death cross? There are some people (those that must not care about probabilities) that use the death cross as a signal to sell their stocks. Like all things involved with TA, sometimes it works and sometimes it doesn’t.  Either way … gotta have a plan and this is, well … at least a plan. As it turns out, not a statistically profitable one. A death cross on small cap stocks has not been historically threatening at all. In fact, it’s just the opposite. The good folks at quantifiableedges.com did a study that looked at what stock market returns had been after small cap stocks formed a death cross. Here are their comments and results regarding their death cross study …

“It is being promoted as a warning of a potential bear market. Of course, all bear markets will see this happen at some point, because a bear market is an extended decline. But the real question when considering the implications of the Death Cross are whether it serves any value in predicting a bear market. To answer this, I did an examination of past Russell Death Crosses, and what they meant for the S&P 500. Both of my data sources show Russell data back to late 1987. And since I need 200 days to calculate a 200-day moving average, the earliest the study could look back to was 1988”.

In their study, they purchased a hypothetical $100k in the SP500 stock index, each time a death cross occurred in the small cap index and sold the index once the 50 day moving average crossed back above the 200 day moving average. If the death cross were a viable stock market sell signal, this study should show a loss since we are doing just the opposite of the “signal” … here are the stats, profit curve of the hypothetical trade and ending comments. “

bay area financial advisor and NAPFA cfp retirement planner - death cross - 11-19-18.png

“Eighteen winners. Only three losers. So 86% of the “predictions” were wrong” and a total net profit of over $78,000 on a $100,000 investment. As such “I am having a hard time seeing the Russell 2000 Death Cross as a bearish indication. You would have a much easier time convincing me this is a bullish indication for the intermediate-term.”

When it’s this Obvious

Classic charting 101 shows an almost ideal (too perfect?) head and shoulders reversal pattern that has developed on Goldman Sachs, GS. When patterns are this obvious, watched by so many traders/ investors, I have found they usually don’t work. Usually ….

San Ramon fee only NAPFA CFP & financial planning investment advisor 11-14-18 -  GS.png

It’s important to note the pattern has not yet triggered so until it does, it is nothing more than a picture of beauty and something that “could be”. If, on the other hand, it does trigger and play out

1)     The pattern’s target is down at “T1”.

2)     The target decline is ~32%.

3)     It would likely occur very quickly as there is little support until you reach the $165 level.

4)     The financial sector would be in a world of hurt as it would likely mirror GS’ decline.

5)     The US stock market would likely have a much, much further fall in store as its, arguably most important sector, would be falling precipitously.

6)     It couldn’t happen to a nicer company (the “evil squid”)

Under the Dome

October turned out to be a brutal month for stocks causing a lot of technical damage as you can see when you look under the hood of the indexes at individual stocks. So many have begun to rollover after forming longer term topping patterns, a precursor and setup for potential bigger declines. A good example can be seen in the chart of Charles Schwab, SCHW.

As you can see over the last year, the price of SCWH has transitioned from being in an uptrend (higher highs and higher lows) to now being in a downtrend (lower highs and lower lows). Notice how the $49 area has acted as support during the entire transition. October’s selloff finally pushed the stock below support which opened the door for a quick flush and an almost 19% decline in 10 short trading sessions.

What Was Support is Now Resistance

As with most selloffs, this one too ran out of steam on capitulatory volume and on an oversold RSI momentum as the dip buyers and opportunistic traders stepped in to reverse prices higher. Higher they went to take back the majority of October’s decline. Notice where the recent rally stalled? Right where is should … the $49 area.  When support ($49) is broken from the top it becomes resistance ($49) from the bottom.

This is a great opportunity for short sellers to take a position, just under resistance. If SCHW rolls over to retest October’s lows, or even extend beyond there is at least a 15% return opportunity. To manage risk, if you are short there is no reason to hold the position if price moves back above resistance which would subject you to a small 3-4% loss. This works out to be a more than 3:1 reward to risk ratio, right in the sweet spot for risk capital opportunities.