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Wednesday, July 18, 2012

What is the "Death Cross"?

Stock analysis falls into two distinct buckets:  fundamental analysis and technical analysis.  Fundamental analysis involves studying financial reports, industry trends, etc.  Technical analysis, on the other hand, studies charts and looks for patterns.  A big deal in technical analysis is when moving averages break key levels.

What is a Moving Average?

A moving average is constructed by dropping a term in the past and adding the most recent term and then taking the average.  As a simple example, consider a 5-day moving average of the temperature.  Today we would add the daily temperatures of the past 5 days and take the average.  Tomorrow we would drop the oldest day and add in the new temperature and again calculate the average temperature.  Continue for a period of time and you get a numerical sense of whether it is getting cooler or warmer.

If you want a challenge, see if you can find a bored teenager (easy part) who can calculate and graph a 5-day moving average of the temperature over the next 10 days without a calculator.  Good luck!

The Death Cross

Short-term trends relative to long-term trends are significant in technical analysis.  These are captured by various moving averages derived from laborious studies of past data.  One that stands out is the 50-day moving average relative to the 200-day moving average.  When the 50-day average moves above or below the longer term 200-day average, it gives the technician an important signal of a buy or sell, respectively.  It is an important tool in the kit of those who follow this approach.

Well, the "Ultimate Death Cross" to which Albert Edwards, of Societe Generale, has alerted the investment community is the impending fall of the 50-month moving average of the S&P 500 through the 200-month moving average.  In the past, including Japan in 1988, this has been followed by a long-term bear market.

Edwards adds in that declining analyst optimism data also implies a pending bear market.

Stay tuned!

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