Prepare for a large dose of mainstream financial media panic since the death cross is now imminent after the large drop on Tuesday, December 4, 2018..
This is another indication that these signals may be self-fulfilling prophecies and manifestations of financial reflexivity. There were constant references to a pending death cross in S&P 500 in the last two weeks. Normally, this death cross should have taken a little longer but events in anticipation of it accelerated the timing of the formation and especially the large drop on Tuesday, December 4, 2018. Investors and traders do not like to get caught in a stampede and act before signals occur. But this accelerates the formation of the signals and contributes to the phenomenon that has been called “reflexivity.”
Based on moving average one-day ahead projections, any close on Friday, December 7, 2018, below 2879 will trigger a death cross and therefore for all practical purposes the signal is inevitable now:
I assume that the S&P 500 will not gain more than 6.78% on Friday, December 7, 2018, and the death cross to occur. Although everything is possible in these markets, such a large gain is unlikely. It is even more likely that the market will go down as some will attempt to preemptively get out.
Trading these death crosses has generated random results, as shown in the backtest below. The entry is on the day of a death cross and the exit is after 20 trading days or in case of a golden cross, whichever comes first.
Based on 28 trades since 1960, win rate is 32% and overall return is less than 3%, resulting in an annualized return of about 0.05%.
The death cross, in a self-fulfilling prophecy mode, is a signal for protecting profits rather than an alpha strategy. Below is a backtest of the strategy that goes long on a golden cross and exits on a death cross:
Although on an absolute return basis the strategy has not done much better than buy and hold, on a risk-adjusted basis it outperforms: MAR is 0.12 for buying and holding versus 0.20 for the strategy. This difference can help reducing pain during bear market and this is the advantage of this trivial strategy. However, this strategy also hides increased tail risks in case of a prolonged consolidation in U.S. equity markets that has not happened before, similar to the one that occurred in recent years in emerging markets. More information about trend-following advantages and perils can be found in the trader education section.
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Charting and backtesting program: Amibroker