On Golden Cross

 | Feb 01, 2012 | 1:00 PM EST  | Comments
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This commentary originally appeared Feb.1 at 10 a.m. on Real Money Pro – Click here to learn about this dynamic market information service for active traders.

Tuesday, the S&P 500 finally achieved the golden cross that has been so lauded in the financial press this week. The golden cross occurs when the 50-day moving average crosses above the 200-day moving average on an index, sector or stock.

What does a golden cross actually tell us? It says that the average price of the index or stock has been higher for the past 50 days than it was for the past 200. The crossover of the two averages represents momentum. Really, it tells us that the index has been stronger in the past two-and-a-half months than it has been over the 10 months (there are approximately 20.8 trading days per month, on average).

But moving averages are lagging indicators; the fact that the performance of an index is improving doesn't automatically mean that it will continue to improve. That is the crux of the problem with lagging indicators: just because an index has been gaining strength, it doesn't mean that it will continue to strengthen. Because moving averages are lagging, the golden cross is a lagging indicator.

Most of the recent instances of the golden cross have been successful, but most of the statistics that champion this indicator only count occurrences beginning from the 1960s. There is no question that the golden cross has a stellar track record over the past 50 years, but between 1930 and 1960 there were 11 instances of the golden cross on the S&P Composite Index and during these years the indicator was correct approximately half the time, which means it gave no edge at all.

If the golden cross is an effective indicator of a bull market, does that mean its polar opposite, the dark cross, is also effective? Apparently not; the dark cross has actually been a fairly effective buy signal. The average S&P 500 return on the dark cross is slightly positive. This may be due to bear markets tending to be shorter than bull markets -- by the time the dark cross signal has occurred, it's usually too late to sell.

Instead of simply using a golden cross to determine if the stock market will rise, we could place our 50- and 200-day moving averages on charts of different sectors or individual stocks to gauge their relative performances. For example, the retail sector, represented here by SPDR S&P Retail Fund (XRT) performed a golden cross on Dec. 5 of last year, indicating that the sector was stronger than the overall market. XRT bounced off resistance from its prior high from July of last year, just above $56. The exchange-traded fund is now due for a pullback to its trendline area at about $54. I'd consider stepping in at that level.

Meanwhile, some of the lagging sectors haven't even come close to creating a golden cross, indicating that they are weaker than the overall market. For example, the 50-day MA (blue) of the SPDR Select Sector Financial Fund (XLF) is still well below its 200-day MA (red):

Finally, everyone knows by now that Amazon (AMZN) was roughed up when it reported earnings after Tuesday's close. What clues were in the charts prior to yesterday's debacle? How about the fact that AMZN was performing a dark cross while the rest of the market was preparing to take off? AMZN has been trapped beneath its 200-day MA for two months.

In Dec. 30's "The Long and Short of It" I wrote of AMZN, "This is an ugly chart and yesterday's intraday rally notwithstanding, I'm staying short as I look for the downtrend to continue." Shout out to Real Money's Brian Sozzi who also nailed AMZN with his call.

Based on recent effectiveness, you have to give the golden cross some respect. It means there's a good chance that the market will go higher. But we can't ignore the fact that there have been long stretches where it was basically useless. It's a positive factor, but used alone it's not enough. I consider it a decision-support tool rather than a decision-making tool.

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