It's official, on August 11, the S&P's 50-day simple moving average ( SMA ) sliced below the 200-day SMA. This condition is dramatically called the death cross.
The death cross has foreshadowed some remarkable market meltdowns (-46% in 2000 and -55% in 2007) and shouldn't be ignored. However, it also has one serious flaw.
Just a few months ago the S&P was trading at 1,370. Those were golden times, but they've passed. Reality paid a visit and the S&P dropped as much as 267 points, or 19.48%.
The S&P has recovered somewhat but is still 15% below the May high. If you're holding on to long positions until you get the crossover sell signal (or death cross), the last few months have been a grueling experience.
Why? Simply because your sell signal has been late to the party, 15% too late.
The Serious Flaw
Merely using the SMA crossover as buy/signal is like having to wait for an important document sent via snail mail when it could have just been sent via e-mail.
Yet, that's exactly what the financial media is doing - investment advice in the snail mail format. To illustrate what I mean, allow me to quote some headlines featured around May 2, 2011:
'The S&P Breaks Out'
'Sales growth the Big Surprise on Wall Street'
'Why Berkshire and Buffett Never Lose'
'World revs up U.S. Profits'
'Geithner: No risk U.S. will lose AAA Credit Rating'
Quite to the contrary, the May 1 ETF Profit Strategy Newsletter update showed two revealing charts (the first chart is shown below) and commented:
'The first two charts update the S&P's position relative to various resistance levels and the ideal target range for a potentially historic market top. The first chart provides a big picture snapshot going back as far as 1997. As mentioned before, the ideal target range is between 1,369 and 1,382. 1,369 is a Fibonacci projection level going back to the 2002 market low. A move to 1,369 would be close enough to consider the right side of the giant M-pattern as completed.'
On July 28 the ETF Profit Strategy update commented about support at the 200-day simple moving average ( SMA ): 'A break below the 200-day SMA and the trend line may trigger panic selling. One way to avoid missing out on a potentially big opportunity is to use the 200-day SMA at 1,284 as delineation between bullish and bearish bets - buy as long as the 200-day SMA serves as support, sell if it becomes resistance.'
The death cross (like Wall Street and the financial media) is like a seemingly concerned bystander offering you an umbrella after you've gotten trenched by the rain.
Death Cross Track Record
How big of a deal is the death cross? A picture (or table) says more than a thousand words. The table below shows every death or golden cross since 2000. A golden cross is the opposite of the death cross.
As you can see, the death cross - albeit late - has protected investors from much more severe declines in 2000 and 2007. There were some false alarms, but the damage of the misfires were miniscule compared to the benefit of the warnings which is reflected in the 19.7% average gain of a winning trade (7.6% average loss for a losing trade).
To sum it up in one sentence, the SMA crossover is correct 6 out of 10 times with a risk/reward ratio of 3:1 in favor of the investor.
One interesting little factoid about the 2000 and 2007 death crosses is that the sell signal - albeit late - occurred right before the next powerful decline.
In 2000 and 2007, stocks rallied for about three days before the grip of the death cross took hold and drew the major averages a la S&P (SNP: ^GSPC), Dow Jones (DJI: ^DJI), Nasdaq (Nasdaq: ^IXIC) and Russell 2000 (Chicago Options: ^RUT) significantly lower while propelling the VIX (Chicago Options: ^VIX).
Super Charge the Crossover Sell Signal
This harmonizes with our analysis that there's a good chance stocks will drop to a new low.
Fortunately since we've been either in cash or short stocks since S&P 1,340, we do not feel the need to chase the market. Right now it's best to simply follow the market's lead. What does that mean?
If you look at a chart of the S&P 500 you will see that on each of the last four days the S&P has closed either at 1,173 or 1,121. Already in June the ETF Profit Strategy Newsletter pinpointed S&P 1,170 is important support/resistance level.
On July 15 the newsletter reiterated: 'A close below this year's low at 1,249 on the other hand would probably mean that a major market top has been reached and should minimally lead to S&P 1,229 or 1,170.'
The August 4 update again highlighted the importance of 1,121 and 1,173. No doubt the S&P will break out of this range soon, but until it does - and even once it does - 1,173 and 1,121 are important inflection points.
Trade above either level keeps the notion of higher prices on the table while trade below would point towards lower prices and quite possibly a new low.
The ETF Profit Strategy Newsletter boils down complex technical analysis into easy to understand support/resistance levels and actionable buy/sell recommendations. It also provides the target level for the ultimate low and the top end of any counter trend rally.