The Dangers of The Death Cross Indicator

Apparently, the major financial media outlets decided they wanted to pretend to care about market indicators this month. We’re not talking Bollinger Bands or a Fibonacci Retracement or a Sharpe Ratio, but the most ominous market indicator out there, The Death Cross. It’s the market indicator that strikes fear into those who just heard that such an indicator exists.

It just so happens that the Dow Jones Index crossed this fear striking indicator this month for the first time since 2011.

Death Cross Bloomberg(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Bloomberg

Not to worry, stock market bulls – Guru Barry Ritholtz was hot on the job dispelling the idea that this is any reason to fear a market correction or downturn.

“Myths that become Wall Street rules of thumb have existed for as long as there have been trading desks. They are legion, they pop up regularly and most of the time they are terribly wrong. Woe to the unwary trader who relies on the urban legends to inform an outlook.”

What is the Death Cross?

Technically, it is when the average closing price of the past 50 days “crosses” below the average closing price of the past 200 days. When plotting these averages on a chart, as above, you get ‘moving averages’, which tick up and down each day when a new closing price is added to the average, and the price 51 or 201 days ago dropped from the average. The 50 day moving average moving below the 200 day moving average tells us the current environment is weaker than it has been, perhaps signaling a market top. The Golden Cross, conversely, is when the opposite happens, with the 50 day moving average crossing above the 200 day average.

Is the Death Cross a Premonition of Dark days Ahead?

Is this the moment we’ll all look back on as the time this already long in the tooth bull market ended?  Is the Death Cross as deadly as its name suggests?  According to Bespoke Investment Group, via Ritholtz, it turns out that this market idiom isn’t all that accurate of an indicator:

“Looking at the past 100 years, they wrote that “the index has tended to bounce back more often than not.” Shorter term (one to three months), however, these crosses have been followed by modest declines in the index. 

How modest? The average decline is 0.17 percent during the next month and 1.52 percent the next three months. By comparison, Bespoke notes, during the past 100 years the Dow averages a 0.62 percent gain during all one-month periods and a 1.82 percent rise during all three-month periods.” 

So it’s useless?

As a single indicator to dictate your entire asset allocation strategy, yes, it’s useless. As a tool to gauge market strength and inform your stock market exposure, it may have some value. But its real value is likely as a systematic trigger to signal the beginning of a trend, on top of which you layer risk control, position sizing, target returns, and all the rest.

How Trend Followers Use Market Indicators like the Death Cross:

Using different aspects of a market’s price relative to one another is one way to determine the start of a trend. These so called relative price models are less concerned with if a market has broken out of a range and more concerned with whether recent prices are stronger or weaker than past prices. A Simple Moving Average Cross Over method (like the Death and Golden Crosses) is the classic example of this, and it entails buying or selling when two moving averages of differing time periods (such as the 20-day and 100-day moving average, or 50/100, or 50/200) cross over one another. The shorter term moving average is used as the trigger, signaling a buy when it crosses above the longer term average, and a sell when crossing back below the average.  On top of this buy and sell signal, a systematic trader will have a pre-determined percent of equity to risk on the trade, which will equate to an exit point designed to not risk more than that amount.

There’s Death Crosses (and Golden Crosses) weekly…

The thing the press ignores about the Death Cross is that you can apply mathematics to any market, and there are 100s of tradeable markets around the globe, meaning there are Death Crosses, and their opposite, likely any day of the week if looking across markets as varied as Cocoa, Japanese Bonds, Swiss Francs, and Crude Oil.  Ritholtz sort of points this out, saying that using the Dow Jones as the overall market gauge can be dangerous as it isn’t a true presentation of the entire market; and we’ll add that it definitely isn’t a true presentation of all markets.

As proof of concept, we can see that more than half of the sectors in the S&P 500 currently have their 50 day MAs below the 200 day ones, showing there’s more than one way to find a Death Cross out there.

Death Cross S&P500(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: AMP Capital

It’s not where you get in, it’s where you get out:

Which brings us to this chart showing all of the time (shaded blue) the S&P has been in a ‘death cross’, with the 50 day MA below the 200 day MA. Looks to us like about 35% of that chart is shaded blue, if not more. But more telling is where the price is when the blue changes back to white. You can see in periods like 1981 that the Death Cross was a good signal for calling a top (despite failing to call such a top in ’78 and ‘79), but that prices had come all the way back, and even above the prior level, before there was a Golden Cross telling you the trend was over…

That problem, more than anything else, is what makes the Death Cross “terribly wrong” in Ritholtz’s words. The Death Cross is ok at showing you when prices will turn lower, but give absolutely no information as to whether that turn lower will last 1 month or 4 years. It’s useless as a signal without overlaying risk control, position sizing, and a method (different than the Golden Cross) for getting out.

Death Cross S&P 500 all time(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: AMP Capital

So, don’t go mortgaging your house to put on the mother of all short trades on this most recent Death Cross.  But beware tossing it out with the bathwater as well. It has real value to systematic traders, when put to use across multiple markets and overlay other indicators and money management techniques on top of it.   In the end, if you have stock exposure, you should probably, as Ritholtz suggests, just let stocks do what they’ll do, and not jump at reasons like this to lighten up. If you’re worried about the downside, the better approach is to instead look for non-correlated diversification in your portfolio, for when the Death Cross does become the next crisis.

A Wealth of (Managed Futures) Common Sense

If you haven’t had the chance to check out the work of Ben Carlson over on his blog, “A Wealth of Common Sense,” we highly suggest it. We’ve written about his thoughts and ideas a couple times (here and here) and we couldn’t help but notice the subject of his musings on doing what works for you in his latest post, “The Importance of Intellectual Honesty in the Markets” is of Managed Futures.

“Managed Futures is a trend following strategy that trades futures contracts both long and short depending on the direction of the markets. The strategies are typically diversified across stocks, bonds, interest rates, commodities and currencies and follow a systematic approach. Also called CTAs (commodity trading advisors), these funds got a ton of attention following the 2008 crash because they were one of the few places to earn positive returns when stock markets around the globe sold off anywhere between 35-55%.

I looked at the Credit Suisse Managed Futures Index going back to 2008 and compared it to the annual returns on stocks, bonds and a 60/40 stock/bond portfolio through June of this year:

Asset Class Performance since 2008(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: A Wealth of Common Sense

But it wasn’t just his feature of explaining the asset class of Managed Futures, it’s about how investors tend to chase performance, getting in at the highs and out at the lows. As Ben puts it:

“The biggest problem most investors face is that they invest in something like managed futures after they see the impressive results it had in 2008. Then they bail when it falters. Or they change their strategy to a low cost indexed buy and hold approach after seeing how well it’s done since 2009. Once again, many will bail during the inevitable down period.”

Which fits quite nicely with our “In at the Highs out at the Lows” Managed Futures chart.

Managed-Futures-Performance-vs-asset-flow-1024x521(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: In at the Highs, Out at the Lows 

Back to Ben Carlson:

“Despite these numbers, I don’t think it makes sense to completely write off (or pile into) a strategy simply because it’s had a poor (or good) run over the past cycle. This is just one fairly short time frame. I’m all about intellectual honesty when discussing the markets. I don’t believe in disparaging someone else’s strategy just because I don’t invest that way. My motto has always been, ‘do what works for you, as long as it helps you reach your goals and allows you to sleep at night.”

We couldn’t have said it better ourselves, but since we’re in the Managed Futures space, we can’t help but take it a step further. We want to add one of Ben’s sentences.

“It’s worth noting that the Credit Suisse index isn’t representative of all trend following strategies, but it does give you an idea about the struggles the space has endured following the crash.”

The fact that the index isn’t representative of all trend following strategies is definitely worth noting, and shows Mr. Carlson is no newcomer to this game. But here’s where things get even a little more interesting. Because not only is the index not representative of all trend following- but trend following is not representative of all Managed Futures. As we talk about in our Managed Futures strategy review every year, there’s also Short Term, Multi-Strategy, Specialty, Agriculture, Spread, and Options strategies.  Not to mention the managed futures-like Global Macro programs. Which is why those who find managed futures ‘works for them’, in Ben’s parlance; may not have found it to be as much of a struggle as the chart suggests.

For instance, in 2013, the Barclayhedge Agricultural Traders sub index was up 5.71%, when the Credit Suisse index was down -2.6%. In 2011, The Barclayhedge Discretionary Traders Index was up +2.75%, while Credit Suisse was down -4.2%. In 2012, the Attain Short Term Fund was up 10.29%% while the Credit Suisse was down -2.9%. {Disclaimer: Past performance is not necessarily indicative of future results}. Of course, you would need a crystal ball to know which of those sub strategies was going to perform each year and which weren’t; but you get the point. Just like small cap stocks can diverge from large cap, or Asian stocks be up while US stocks down; different types of managed futures strategies can, and will (and have), diverge from the poster child trend following strategy. That’s why our Philosophy is to surround a core allocation to trend following with these other strategies to ‘diversify the diversifier’.

How about a Longer View:

Which brings us to a tweet asking for a little more data – something we’re happy to dive into.

 

 

Here’s what a 60/40 portfolio looks like using Carlson’s same table, with the Sharpe ratio added in to compare the different return and volatility levels (although you know we’re not huge fans of the Sharpe):

Asset Class Ratio Addition of Managed Futures
(Disclaimer: Past performance is not necessarily indicative of future results)
Data = (60/30 MF) is 60% SPY & 40% DJCS Managed Futures Index
Other data from: A Wealth of Common Sense

But as Mr. Carlson said, this is a “fairly short time frame.” What does it look like if we push it out back to the inception of the Credit Suisse index?  And while we’re at it, we’ll be the first to tell you managed futures isn’t meant to replace bonds (although that might not be a terrible idea in a rising rate environment). So what does it look like when diversified into managed futures and Bonds with an allocation of (45% Stocks / 28% Bonds / 30% Managed Futures)? Here you go:

Ratio Two 1994-2015
(Disclaimer: Past performance is not necessarily indicative of future results)
Data: DJCS Managed Futures Index
S&P 500 = SPY Bonds = Barclays Global Aggregate Bond Index

You can see argument for a managed futures allocation in these longer term stats, which speaks directly to Carlson’s main point:

“I don’t think it makes sense to completely write off (or pile into) a strategy simply because it’s had a poor (or good) run over the past cycle.”

For more information on Managed Futures Performance, check out our Whitepaper highlighting the “Performance Profile: Managed Futures

An Alternative Way to view Diversification

We’re living in a post 2008-2009 financial crisis world. Investors and advisors alike know that having your eggs all in one basket could land you in some hot water (especially if it’s the arguably broken 60/40 portfolio). The reason being, one single person or group isn’t able to call what’s going to be the “best” asset class (by performance only) in any given year.

Enter the ever so popular diversification quilt, which essentially ranks each asset class top to bottom over the past 15 years. The issue, of course, is that although they include 10 asset classes, they really don’t include alternative investments, specifically Managed Futures. The latest to release a chart like this is Business Insider.

 

As you might remember, we took the liberty of changing around the “quilts” published by Bloomberg back in September by adding Managed Futures to the mix. The second issue with the quilt table is that these “quilts” are all on the same axis level. For example, if an investment was the worst performer of the year and still up 2 or 3 percent, it would look the same as an investment that came in last at a -10% on a different year.

Which got us thinking how different would the table look if we spread out the investments so that the performance range would be visible? This is what we got.

P.S – Looking at each asset class on its own fluctuates year to year, is just one way to look at volatility. So, so we connected the dots of the largest performance range (Emerging Markets), Managed Futures, and the smallest performance range (Cash).

(Click here for a better view)

Diversification Chart Past 15 Years Logo

(Past performance is not necessarily indicative of future results)
Source:
Large Cap = S&P 500
Small Cap = Russell 2000
Intl Stocks = MSCI EAFE
Emerging Markets = MSCI Emerging Markets
REIT = FTSE NAREIT All Equity Index
HG Bond = Barclay’s U.S. Aggregate Bond Index
HY Bond =BoAML US High Yield Master II
Cash= 3 Month T Bill Rate
AA = Asset Allocation Portfolio
(15% Large Cap, 15% Intl Stocks, 10% Small Cap, 10% Emerging Markets, 10%  REIT,
40% HG Bond

Alternative Investors are Asking the Wrong Questions

As the registered investment advisor space continues to grow, and the use of Alternative Investments by those advisors continues to grow; we find ourselves talking with more and more ‘RIAs’, helping them truly understand what’s under the hood of the managed futures labeled mutual fund or private placement they’re considering.

Which brings us to Wealthmanagement.com, a popular spot for advisors to keep tabs on the industry and find commentary and research to help in their ongoing education, where our own Jeff Malec has been asked to post a few pieces on Alternative Investments:

Investing in alternatives has become all the rave the past few years, but there isn’t quite as much literature out there as in the traditional investment space (by a factor of about 1000 to 1), which leads to a lot of well intentioned due diligence and pre-investment questions to really miss the mark.

The essential question is: “how has it performed recently?” But that’s just the tip of the questionable question iceberg. Here’s a few more we hear from time to time, with suggestions for more insightful inquiries:

Question/Idea The Flaw(s) in the Question A Better Question
How much is it up this year?The performance day to day, month to month, and even year to year is virtually random – Remember: past performance does not indicate future results.Can you explain to me why the investment is up/down/sideways so far this year (or in xx year) for me to better understand your investment philosophy?
Every alternative investment will help diversify my portfolio with non-correlated assets.There are a lot of products out there that have ‘alternatives’ on the label – but when it comes to return drivers and true diversification – not so much. Many of these alternatives rely on freely moving credit markets, a rising economic environment, and strong corporate earnings.How is the investment likely to react in a concentrated sell off across asset classes? What are the main return drivers?
Is the Sharpe Ratio high enough?The Sharpe has numerous flaws, outlined here, but what you need to know is that there’s more to risk than volatility.How are the returns per unit of: downside volatility, the max drawdown, and average annual drawdown?
Am I getting commodity exposure?A yes answer here doesn’t help. How much? Long and short? One popular ‘trend following’ model doesn’t even go short energies… a tough pill to swallow as Crude went from $100 to $50What percent of historical returns have come from physical commodity markets? Does the investment go both long and ‘short’ commodity markets?
I need daily/weekly/monthly liquidity… does this investment allow me to get out quickly?Daily liquidity is like sleeping with a gun under your pillow for protection. You’re more likely to accidentally shoot yourself than protect anything. Needing instant liquidity for investments that can take 3-5 years to run a full cycle is a mismatch.What are the liquidity constraints so I can fit this into the appropriate liquidity bucket in my portfolio, and know whether or not I can count on it in a pinch.
This is a managed futures program… great! I’ve been looking to add that asset class to help protect my portfolio in a market correction.There are a lot of products that trade futures markets, but are anything but classic managed futures programs, trading stock index futures and such or doing counter-trend models.Will this provide the negative correlation/crisis period performance managed futures are known for?

Adding ‘alternatives’ to your portfolio has never been as easy as today with the plethora of so called ‘liquid alternatives’. And the marketers have never had such an easy time separating the uninformed from their money in their bids to raise money for these funds. For example, a prominent national firm we will leave unnamed put out a 5-page piece explaining how to utilize 15 different hedge fund strategies in portfolio construction. It has all you would ever need to know about these highly complex investments, dedicating four to six sentences to each one!

Four to six sentences. That’s all you need to know? So much for the Chartered Alternative Investment Analyst designation or decades of experience with the asset class. Just grab the nifty cheat sheet here and start building portfolios – what could go wrong? What could go wrong indeed – how about mismatched performance with investor expectations, high fees, poor relative performance to benchmarks, a concentration in the largest managers counterparty risk, credit risk, and the propensity of the correlations and relationships listed all blowing up during a crisis.

Marketers, take note: keeping it simple is how you sell a complex idea to investors. Investors, take note: it’s a lot more complex than that—you have to ask the right questions.

 

Alternative Links: Winton’s Milestone

Winton:

David Harding’s Winton Capital Passes $30 Billion for First Time – (Bloomberg)

Our Interview with David Harding – (Attains Alternatives Blog)

Managed Futures & Currencies:

The Almighty U.S. Dollar – (MorningStar)

Long the U.S. Dollar and Loving It – (Attains Alternatives Blog)

A Look a the Euro by the Numbers – (Attains Alternatives Blog)

Managed Futures Predictions:

5 Predictions for Managed Futures post 2014 – (CTA Intelligence)

Managed Futures 2014 Review & 2015 Outlook – (Attains Alternatives Blog)

Proprietary Trading:

Proprietary trading: truth and fiction – (Peter Muller)

Diversification:

Diversification Means Always Having to Say You’re Sorry – (The Investor’s Paradox)

Diversification Sucks – (Attains Alternatives Blog)

Commodities:

Commodities – Time To Start Reloading – (ValueWalk)

WHY IT’S A BOOM TIME FOR PALM OIL: INTERVIEW WITH CHONG KIM SENG – (Open Markets)

Robo-Advisors:

Broken Values & Bottom Lines – (Medium)

Alternatives:

Vanguard tiptoes into the liquid alternatives market – (Investment News)