If you haven't heard, the chart for the Dow Jones Industrial Average formed a special pattern this month that technical analysts call the "death cross."
I'll wait a moment to let the fear wash over you.
Now that you've regained your senses, I hope, let's go ahead and dispel this ridiculous notion. The Dow "death cross" is a laughably bad indicator, and I'm going to prove it to you.
Technicals are way overrated
If you haven't yet figured it out, I'm not a big fan of technical analysis. It's just never made sense to me. I can understand why a customer may buy Product A instead of Product B. I can understand why a management team may choose to implement a cost-cutting program to boost margins. I can understand why a stock with a higher dividend yield could be more attractive than another without a dividend.
But I've never been able to wrap my head around how a stock's pricing yesterday, or last week, or last year, has any bearing whatsoever on the stock's price tomorrow. Maybe I'm just dense. But I don't think so.
This "death cross" is particularly annoying to me because there seems to be some disagreement on how it's even defined. In the course of my research, I found several definitions, each with increasing levels of nuance and exceptions -- the kind of thing you'd expect to hear from snake-oil salesmen explaining why their magic potion didn't work as advertised.
The most common definition is pretty simple. A death cross happens when the 50-day moving average of a stock or index crosses below the 200-day moving average of the same stock or index. OK, that's simple enough.
But others say that definition is insufficient -- probably because it doesn't work. They define the death cross as what I just mentioned, except it counts only if there are sufficiently high trading volumes to validate the signal.
I get how low trading volumes could distort the market's movements in the short term, but I still don't see the relevance of this special little pattern.
But wait! It gets better. Other technical analysts have even more definitions for the death cross. Some say the death cross works only when the pattern forms and the 50-day average remains below the 200-day average for a period of time. Others say it works but that it's two other moving averages that actually create the death cross.
If you spend a little time searching the interwebs, you'll find even more ways to define the death cross. To me, it's ridiculous.
The definition of the death cross, whatever definition you choose, is arbitrary
With a name like "death cross," you'd hope that this terrible thing only comes around once every few hundred years, or never at all. Some technical analysts would have you believe that it's pretty rare.
Well, the reality is that it isn't rare at all. Not only that, but it also doesn't really predict anything, bear or bull.
Since the late 1800s, there's been a "death cross" pattern in the Dow about every 16 months. There was one in 2011. The market went up. There was one in 2010. Stocks rose. There was another in 2004. Yes, stocks went up that time too.
There have been others as well, and sometimes the market fell after the pattern. Sometimes. Not every time.
Let us not forget that the 50-day and 200-day moving averages are just numbers calculated from historical stock prices and put onto a chart. They show an analysis of what happened, but they don't provide any insight into why anything happened. From where I'm sitting, the why is far, far more important than the what, particularly when you're trying to figure out what's going to happen next.
Short-term market movements don't necessarily indicate a change in fundamentals.
Earlier this month, the Chinese Central Bank allowed the yuan currency to devalue against the dollar. That macroeconomic event is largely attributed with driving the market decline that led to the death cross.
Yes, a devalued yuan can affect export and import prices. But if this "death cross" is to be believed, then we are on the cusp of a 20%-plus market decline. I don't see that happening as a result of this shift in Chinese monetary policy. And more to the point, it's certainly going to take more than just the intersection of two moving averages to do that kind of market damage.
Historical precedence has shown that the death cross could mean that the market is about to go down. Or up. We're really not sure which way.
It's a hilariously arbitrary construction. All it truly means is that the market has been down lately. That's it. Nothing else. It's merely a reflection of short-term history. Any interpretation beyond that is fortune-telling.
Ignore the "death cross." Why not focus on the fundamentals of a strong company instead? That analysis is actually based in reality.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Starbucks and Wells Fargo. The Motley Fool owns shares of Starbucks and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.