Last Updated on April 19, 2022 by Quantified Trading
The Death Cross in trading is a widely cited phenomenon in the financial media. As of writing, the media is full of stories about the price of Bitcoin being close to the Death Cross. In this article, we look at the performance of the Death Cross in the S&P 500.
A Death Cross involves two moving averages – one short and one long, normally the 50 and 200-day moving averages. When the short moving average crosses below the long one, a Death Cross is formed. As a trading signal, it works reasonably well. Backtests reveal that the Death Cross signals short-term weakness, but in the long term, it also takes you out of many positions prematurely. If you sell when a Death Cross is formed and reenter when the opposite signal occurs, a Golden Cross, the returns are in line with the long-term averages, but you have less drawdowns (and pain?) along the way.
Let’s start by explaining in more detail what the Death Cross in trading is:
What is the Death Cross in trading?
A Death Cross involves two moving averages – one short and one long. When the short-term moving average descends below and crosses the long-term moving average, we have a Death Cross in trading.
Specifically, the moving averages used are mostly the 50-day and the 200-day averages. Thus, when the 50-day moving average breaks below the 200-day moving average a Death Cross has been formed. For some reason, this breakdown attracts a lot of media attention and a lot of speculation about a potential bear market. Is this for good reason? You’ll find out after our backtests further below.
Let’s show you how a Death Cross looks on a chart:
Death Cross example
Below is a visual example of a Death Cross in the cash index of the S&P 500:
As you can see, in the midst of the Covid crisis in late March 2020 there was a Death Cross. Unfortunately, if you sold, you would hit more or less the exact bottom and be forced to reenter at much higher prices later. The S&P 500 doubled during the next two years!
Is Death Cross good or bad?
Most commentators speculate that a Death Cross signals potential lower prices ahead. However, a moving average only looks back and is a lagging indicator. There is only one way to find out if the Death Cross has any predictive value: we need to backtest and get a decent number of observations. Backtesting works and is a very valuable tool.
Many articles conclude the Death Cross has proven to be a pretty reliable indicator. Presumably, it has predicted some of the worst bear markets: 1929, 1938, 1974, and 2008.
However, it’s also relevant to know all the bull markets it has forced you to sell. The famous investor Peter Lynch said something like this:
Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.
That said, we have great respect for what a simple tool like the 200-day moving average can do: it’s all about defense. A Death Cross might be just as useful as a defensive tool.
Paul Tudor Jones said the following about the 200-day average:
My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.
He might be right. The low in 1933 was 90% lower than the peak in 1929! It’s of course devastating to lose 90% of the value of the assets. That’s one of the reasons why we want to diversify some assets into short-term trading (to offset or mitigate risk). You might want to read our trend following strategy by Meb Faber and Paul Tudor Jones.
Death Cross and time frame
When we are backtesting the Death Cross, which time frame are we looking at? We backtest the Death Cross on daily bars. But how can we conclude if the Death Cross works or can be debunked?
In the backtests below we exit the trade N-days after the signal: between 10 and 200 days with intervals of 10 days – 20 tests in total.
Backtest the Death Cross
Below is a more detailed backtest of the Death Cross. We use 50 and 200-day moving averages and exit after N-days as explained above.
We backtest the Death Cross in the S&P 500 because it’s the only asset we have with data going back many decades (1960).
These are the results from the backtest:
The results indicate that the Death Cross signals lower returns than a random period in the short term (less than 30 days), but for periods longer than 30 days the return is on average positive and more or less in line with the random long-term returns.
What happens if we enter a position on a Death Cross and sell at a Golden Cross (the opposite, see more below)? This is the equity curve:
But the Death Cross only has value as an indicator in the short run. In the long run, the returns gravitate toward the stock market’s long-term returns. The upward drift in the stock market is very strong. In the long run, inflation and productivity gains make stocks go up and the market spends far more time going up than down, something we covered in the anatomy of a bear market.
(You might also want to read what we consider the lowest hanging fruit in the stock market: overnight strategies. We have published three potential overnight trading strategies on our monthly Trading Edges (subscription).)
Combining the Death Cross and Golden Cross In Trading
What happens if we buy the Golden Cross and sell the Death Cross?
A Golden Cross is the opposite signal when the short-term moving average crosses above the long-term moving average. This is the equity curve if we buy a Golden Cross and exit at the next Death Cross:
This is a respectable CAGR of 7% – slightly less than buy and hold but with 30% less time spent in the market but with a lot lower drawdowns than buy and hold.
Obviously, the Death Cross does a decent job of reducing max drawdown, but so does the much simpler 200-day moving average.
What is a Death Cross in trading – conclusions:
The Death Cross in trading is when the short 50-day moving average crosses below the long 200-day moving average. It attracts a lot of media attention, and it serves as a useful indicator in the short run.
The Death Cross and Golden Cross work well together as a trading strategy because it lowers the time spent in the market and thus drawdowns. The Death Cross in trading is all about playing defense.