Everyone wants to have an edge on their competition. When it comes to investing, there are plenty of strategies you can follow. Many long-term investors prefer to concentrate on companies that have lucrative money-making businesses and good prospects for growth well into the future. By discovering innovative companies before the crowd, these investing pioneers can capture huge returns over periods of years or even decades.
By contrast, some investors prefer to look more at the ups and downs of the market than at the businesses that underlie the stocks they trade. Those who follow a strategy known as technical analysis have celebrated recently, because they believe that a key indicator known as the golden cross essentially predicted the big run higher that markets have experienced in 2023. Yet even though that has so far worked well for investors who followed that signal, the performance of golden cross-based strategies over the longer run is mixed.
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What a golden cross is and why it matters to technical analysts
Traders using technical analysis tend to focus primarily on price movements. By looking at various moving averages of prices, they seek to glean insight into the direction of the prevailing trend as well as how long that trend might last before reversing course and moving in the other direction.
In particular, many traders look at the average closing price of individual stocks or stock indexes looking back over various periods. Using a shorter period, such as a 50-day moving average, gives you a figure that responds more quickly to short-term changes and often sees steeper moves. By contrast, longer periods, such as the 200-day moving average, are slower to change course. Once they do, though, the 200-day moving average tends to have more momentum than shorter moving averages.
The golden cross refers to the moment at which the 50-day moving average climbs above the 200-day moving average. For the S&P 500, that moment came in early February. Since then, the S&P has embarked on what many see as a new bull market, moving 5% higher and finishing well over 20% above lows from October 2022.
The pitfalls of the golden cross
Technical analysis isn't perfect, however, and the way the golden cross indicator performs is one example of potential shortcomings. Even in this particular case, investors following the indicator had to maintain their resolve steadfastly in order to avoid missing out on the ensuing bullish move. From early February until the market hit bottom in mid-March, the S&P 500 index dropped about 9%. At the time, many feared that the index would revisit its October lows and move even further downward. It took strict discipline to maintain your calm and wait for the market rebound that followed.
In addition, waiting for a golden cross to happen often means missing out on a big initial move in the index. Again using the most recent indicator as an example, the S&P's most recent golden cross happened with the index at around 4,150. With the market having topped out at about 4,800 in late 2021 and then falling to roughly 3,500 in October 2022, investors following the golden cross strategy would have had to wait until the market had recovered nearly half of its losses from the first three quarters of 2022 before getting back in. That re-entry price also wasn't that much lower than the 4,200 level at which the opposite indicator -- the death cross -- had triggered a sale using the same strategy in March 2022.
Looking back further, the indicator's success rate is mixed. Nearly a third of the time, the market has fallen during the golden cross period. Monte Carlo simulations using past data suggest that investors could make profits using the strategy, but at the cost of more frequent trading and occasional false signals.
Stick to the fundamentals
Technical analysis can be ambiguous, looking obvious in hindsight but not nearly so clear in the moment. That's a big reason why The Motley Fool tends to favor fundamental stock analysis, looking at the underlying business and its prospects for future success. Different investors find success with different strategies, but you shouldn't expect the golden cross indicator to predict every bull market in the future.
