Blog : Beware the Death Cross

by Ed Zwirn on September 24th, 2014

Evidence that the current stock market is currently entering a new, spooky phase - like we need more of that - can be seen in the fascination that has emerged over the past couple of days concerning the so-called Death Cross.

The way it works is like this: The Russell 2000 small-cap index, which is often used in this investment blog as a measurement of the health of penny stocks in general, has lost about 3.5% of its value over the last three trading days. On Monday, the second of these sessions, the index's 50 day moving average had crossed below the 200-day average. The last time this Death Cross occurred, according to the chartists, was in August 2011, and this was followed by a pronounced market slump. Russell 2000 lost 28.7% between Aug. 1 and Nov. 30 of that year, the Dow Jones Industrial Average lost 0.7% and companies of all sizes in between saw their share prices languish.

Before looking into whether or not we are in for a repeat performance of this scenario, it is important to add one disclaimer: As Peter Leeds pointed out in his most recent investment blog, the stock market may well be due for a correction in any case. Volatility is set to rise, whether because of the latest international crises or domestic price bubbles, and market levels are high, making an open question of which chart you want to look at in order to validate your bearish market outlook.

In one sense, the evidence that penny stocks have crossed a decisive threshold is persuasive. The slowdown for Russell 2000 cannot be construed as anything other than a bearish index, not only for small-cap stocks but for the broader market, signifying as it does a decrease of investor risk appetite.

And risk appetite is declining in the current market. Since Thursday's euphoria following the most recent Federal Reserve announcement, which pointed the way toward an extended period of low interest rates, the major indices have all backed off, but the riskiest stocks have fared the worst: While penny stocks lost 3.5%, the NASDAQ Composite fell 1.8%, the Standard & Poor's 500 1.4% and the Dow 1.2%.

But, as another chart I read indicates, the occurrence of Russell 2000 Death Crosses has actually been followed by higher positive returns on an historical basis. A chart from Bespoke Investment Research going back to 1971 shows that penny stocks posted positive returns at a higher frequency following this indicator than they have for all one-, three- and six-month periods in general.

All this is another way of saying that while we really don't have any certainty about the direction of the stock market going forward (for a change), there is reason enough to be spooked. The U.S. economy may have grown 4.2% in the most recent quarter, but it remains doubtful whether or not the economy will grow as quickly at the end of this year as it did in 2013, when GDP rose 4.1% in Q3 and 2.6% in Q4. As indicated by the falling price of oil and other commodities, demand remains slack, and the very real possibility exists of the bursting of mini "bubbles," particularly in the real estate sector.

Compounding these uncertainties is an international situation about as dangerous as anything seen since the Cuban Missile Crisis of the 1960s. As the Jewish High Holy Days are about to start when the sun goes down tonight, the interval between Rosh Hashana, the start of the New Year, and Yom Kippur, the Day of Atonement, which falls this year on Oct. 4, is unfortunately ripe for a harsh breakout of hostilities in the Middle East.

Even as many other worldwide military/"terrorist" actions continue, the action in Syria and Iraq is particularly frightening, and it is hard to see any diffusing of this conflict, unless the partisans of the Islamic State start enthusiatically waving American flags in their videos. Geopolitical uncertainty of this kind only tends to ramp up with a vengeance, and this drives scared money not to stocks but to the "safe haven" of U.S. Treasury debt.

That being said, it never hurts to read the charts. The Death Cross may or may not be all that it's been cranked up to be, but it has a frightening name all the same. The stock market correction that will probably follow it may or may not be a question of cause-and-effect, but there is unfortunately no lack of causes to look at, and any of them could prove to be as frightening as this frightening icon.