How Reliable is the S&P’s ‘Death Cross’ Pattern?

Mechanical chartists say that with the recent stock market collapse, the technical picture of the US S&P 500 have been irreparably deteriorated such that prospects of a decline is vastly greater (which has been rationalized on a forthcoming recession) than from a recovery. The basis of the forecast: the Death Cross or ‘A crossover resulting from a security's long-term moving average breaking above its short-term moving average or support level[1]’.

First of all, I’ve seen this picture and the same call before.

In July of last year, the S&P also experienced a similar death cross. Many articles emphasized on the imminence of a crash[2] that never materialized.

Secondly, I think applying statistics to past performances to generate “feasible” odds on a bet based on the ‘death cross’ represents as sloppy thinking

To wit, betting based on a ‘death cross’ signifies a gambler’s fallacy or fallacy committed when a person assumes that a departure from what occurs on average or in the long term will be corrected in the short term[3].

A coin toss will always have a 50-50 head-tail probability distribution. If the random coin toss exercise would initially result to string of ‘heads’ outcome, the eventual result of this repeated exercise would still result to a 50-50 outcome or a zero average, as shown by the chart below.

As the illustrious mathematician Benoit Mandelbroit wrote[4],

If you repeat a random experiment often enough, the average of the outcomes will converge towards an expected value. With a coin, heads and tails have equal odds. With a die, the side with one spot will come up about a sixth of the time

Applied to the death cross, we see the same probability 50-50, because each event from where the ‘death cross’ appears entails different conditions (finance, market, politics, social, cultural, even time and spatial differences and etc), as earlier argued[5]. It would signify a sheer folly to oversimplify the cause and effect order and speciously apply odds to it.

Proof?

One would hear proponents bluster over the success of the death cross in 2000 and 2007. Obviously the hindsight bias can be very alluring but deceptive. The causal relationship which made the ‘death cross’ seemingly effective in 2000 and 2007 for the US S&P 500 had been mostly due to the boom bust cycles which culminated to a full blown recession or a crisis during the stated periods.

The death cross was last seen in July of last year (green circle above window), but why didn’t it work? The answer, because the death cross had been pulverized by Bernanke’s QE 2.0 (see green circle chart below). When Mr. Bernanke announced QE 2.0, the ‘death cross’ transmogrified into a ‘golden’ cross!!! This shows how human action is greater than historical determinism or chart patterns.

Many mistakenly think that chart patterns has an inherently built in success formula which is magically infallible, as said above, they are not.

Third, not all market crashes has been due to recessions.

The above illustrates the crash of 1962 (upper window) and 1987 (lower window)[6]. This is obviously unrelated to the death cross, however the point is to illustrate that not every stock crash is related to economic activities. The recent crash may or may not overture a recession.

Bottom line: The prospective actions of US Federal Reserve’s Ben Bernanke and European Central Bank’s Jean-Claude Trichet represents as the major forces that determines the success or failure of the death cross (and not statistics nor the pattern in itself). If they force enough inflation, then markets will reverse regardless of what today’s chart patterns indicate. Otherwise, the death cross could confirm the pattern. Yet given the ideological leanings and path dependency of regulators or policymakers, the desire to seek the preservation of the status quo and the protection of the banking class, I think the former is likely the outcome than the latter.

And another thing, we humans are predisposed to look for patterns even when non-exist, that’s a result of our legacy or inheritance from hunter gatherer ancestors’ genes whom looked for patterns in the environment for survival or risked being eaten alive by predators. This behavioural tendency is called clustering illusion[7]. A cognitive bias which we should keep in mind and avoid in this modern world.

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[1] Investopedia.com Death Cross

[2] The Economic Collapse Blog, The Death Cross: Another Sign That We Are On The Verge Of A Recession?, July 5, 2010

[3] Nizkor.org Fallacy: Gambler's Fallacy

[4] Mandelbrot, Benoit B The (mis) Behaviour of Markets, Profile Books p.32

[5] See The Causal Realist Perspective to the Phsix-Peso Bullish Momentum, July 10, 2011

[6] About.com Stock Market History

[7] Wikipedia.org Clustering illusion

World Cup Indicator: Boon Or Bane?

Will the World Cup games, which opened yesterday, portend of a bullish or bearish markets for the coming months?

Frank Holmes of US Global Investors argues that this should be bullish, especially from the perspective of the host country, i.e. South Africa...


So as with mint.com...

Pls click here to redirect link to mint's site to see a crispier image.

But Bespoke Invest sees the historical correlation as "negative"....

According to Bespoke, "both the US and world markets have averaged declines over both periods throughout history. The S&P 500 has averaged a decline of 1.65% during all 18 prior World Cups, and a decline of 0.37% in the three months following. The MSCI World Index, which we only have back to the 1970 World Cup, has averaged a decline of 1.25% during and 4.34% over the following three months. Historically the market has averaged gains over one- and three-month periods, so indices have definitely underperformed during World Cups. Most fans of the sport would take a couple months of declines in the market if it meant their country would win, however."

To my mind, historical patterns are not reliable measures in assessing market prospects because they can be positive and negative depending on the prevailing market and economic conditions then.

Instead, these indicators appeal to people who are only looking for patterns either to confirm their biases or to rationalize market actions.

Besides, major sporting events as the World Cup or the Olympics can only give a temporary boost to the economy. But on a larger picture such events could entail greater costs from the crowding out effect from inefficient government spending relative to private sector investments. In short, gains can be "exaggerated".

As Leander Schaerlaeckens at the ESPN writes, (bold highlights mine)

``People who are excited about hosting a World Cup, write Szymanski and Simon Kuper in "Soccernomics," "are merely expressing in extreme form a conventional belief: that hosting a big sports event can make a place rich."

``In truth, write the authors, while World Cups don't produce much monetary gain, they have been shown in several studies to be good for general happiness among the hosting population and a country's self-esteem. Thabo Mbeki, South Africa's president until September 2008, declared in a speech that the tournament would be "sending ripples of confidence from the Cape to Cairo." It doesn't look bad for a politician looking to get re-elected, either.

"FIFA and the Olympics all enjoy monopoly standings," Baade said. "And that permits them to foist enormous economic cost on those that compete for mega-events like the World Cup. They're in a position to expropriate public funds. The argument is made that we're going to bring in so many non-native spendthrifts that that will offset the expense of stadiums, but there's very little evidence to support that."

``Chances are that like many predecessors South Africa will eventually discover that hosting the World Cup was a poor choice, at least from a financial viewpoint. But by then, FIFA will have moved on to flattering some other country into believing it should pour the money it doesn't have into hosting another glorious edition of the World Cup."

As always, the temporal 'self-esteem' gains are skewed mostly towards grandstanding politicians. And at the end of the day, if revenues expected are not fulfilled, then the carrying costs of the 'country's self-esteem' will eventually be borne by the taxpayers.

In the Philippines, this is called the fiesta mentality.

Seeing Patterns Where None Exist

Below are good examples of a cognitive bias known as Clustering Illusions or seeing patterns where none exist.

Such presentations depends usually on the underlying biases of the commentators or analysts.

For example "bears" would use today's markets in comparison with that of the Great Depression of the 30s as shown below...

From Google charts

Whereas the "bulls" would use the 1970s as a counterexample.

chart from Businessinsider

But the fact is that there is little in common between the 1930s and today (e.g. gold standard versus today's fiat money, deposit insurance, prohibitions in Intestate banking or the McFadden Act & etc...) or between 1970s and today (e.g. China still a communist economy than a mixed economy, globalization, high inflation versus today's "suppressed" inflation) to suggest of a similar dynamic that could accrue to the same outcomes for the markets.

Essentially, this signifies as a logical fallacy known as cum hoc ergo propter hoc or that "correlation does not imply causation".

Importantly, aside from having different operating conditions, political actions (interventionism) during those days had been different in type and in degree, such that the distortions in the economic and financial system greatly varied.

So essentially whatever directions shapes the future will likely be due to "chance" more than actual "analogies" relative to the above examples.

Anyway, I found this "tight" correlation between copper/gold-S&P 500 chart to be quite interesting.

From Trader's Narrative

Although my suspicion is that the correlation between the two could likely be "new" in the sense that the decades of 1980s-2000s saw "opposing" directions between commodities, which had been in a grueling bear market, and the performance of the US stock market, which had boomed in those salad days or during the "great moderation".

Nevertheless, the point of the chart is to show of the bearish disposition of the current market actions, by an analyst who can be described as a perma bear, David Rosenberg.

But again, as earlier pointed out, for every example would be a counter-example. It all depends on the bias of the writers.

Analyzing Predictions

“I’ve been dealing with these big mathematical models of forecasting the economy…I’ve been in the forecasting business for 50 years…I’m no better than I ever was, and nobody else is. Forecasting 50 years ago was as good or as bad as it is today. And the reason is that human nature hasn’t changed. We can’t improve ourselves.” Alan Greenspan

Baseball legend Yogi Berra once quipped on a sarcastic irony on prediction, ``Prediction is very difficult, especially if it's about the future."

Nevertheless prediction has been hardwired into the mankind’s genes with the implicit goal to overcome risks in order to ensure existential continuity of the specie. As Peter Bernstein aptly wrote in Against The Gods, ``The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk…”

Predictions From A Historian’s Perspective

Well, prediction is a tricky business. Since the advancement of science, the scientific model (quantitative) approach has been frequently utilized to determine probabilistic outcomes given defined set of variables.

However, social science appear to be more complex than anticipated, given that people have different scale of values, which are likewise meaningfully influenced by the divergences in time preferences, and also influenced by sundry cognitive biases, which subsequently makes us respond differently even to the same set of conditions.

As mathematician and scientist Professor Benoit Mandelbrot of the Fractal Geometry fame said in a PBS News Hour Interview, ``The basis of weather forecasting is looking from the satellite and seeing the storm coming but not predicting that the storm will form, the behavior of economic phenomenon is far more complicated than the behavior of liquid and gasses” (underscore mine)

Since markets are essentially economic events, the complications is that they represent endemically a menagerie of action-reaction and stimulus-response feedback loop dynamics to which Professor Mandelbroit elucidated in The (Mis)Behaviour Of Markets as, ``prices are determined by endogenous effects peculiar to the inner workings of the markets themselves, rather than solely by the exogenous actions of outside events.”

So given that markets signify more of human action dynamics than the functional state of natural science then our choice in making predictions will be one similar to the work of historians. Murray N. Rothbard makes the appropriate analogy, ``The latter attempts to "predict" the events of the past by explaining their antecedent causes; similarly, the forecaster attempts to predict the events of the future on the basis of present and past events already known. He uses all his nomothetic knowledge, economic, political, military, psychological, and technological; but at best his work is an art rather than an exact science. Thus, some forecasters will inevitably be better than others, and the superior forecasters will make the more successful entrepreneurs, speculators, generals, and bettors on elections or football games.” (all bold underscore mine)

The point is: Markets are likely to exhibit the causal effects from precursory human actions than from math designed economic models that ignore the aspects of human decision making.

Unfortunately the mainstream appears addicted to apply models even if they’ve been proven to be repeatedly unrealistic, either for reputational (need to be seen as pedagogic) or for social affiliations (need to be seen talking the same language) motivations or due to ideological blindspots (dogmatic treatment of economic theories).

Predictions Based On Dumb Luck

Besides, predictions should be weighed from the angles of opportunity costs and the incentives of the forecaster’s standpoint.

When a forecast for a certain direction of the market is unfulfilled, but at worst, goes into substantially to the opposite direction, losses will be real for those who adhered to them.

For instance, many ‘experts’ who predicted the “crash of the stock market” in 2009, when the market soared anywhere from 20-50% based on G-7 and BRIC and key emerging markets, could have bled their customers dry or would have lost 20-50% in profit opportunities from such erroneous predictions.

Yet for them to bluster “I told you so!” because the markets sizably fell this week would signify as “even a broken clock is right twice a day”! This implies that they’ve been right for the wrong reasons or as indicated by Urban Dictionary “success obtained through dumb luck”.

Market predictions shouldn’t translate to an immediate or outright fulfillment but instead focus on mitigating risks and optimizing profits. When markets move violently against a touted position and the forecaster refuses to badge, then it isn’t about “mitigating risks and optimizing profits” nor is it about accuracy, but about being foolishly arrogant or about obstinately adhering to wrong analytical models.

Remember since markets move in only two directions (up or down)… they are going to be right somehow.

Nevertheless successful investing isn’t myopically about being theoretically right or wrong but about generating maximum profits from the right moves and reducing losses on the wrong moves.

Since as human beings we are susceptible to mundane lapses, then investing is about dealing with the magnitude or the scalability of the portfolio and not of the frequency of transactions. In addition, it is also about the allocative distribution of a portfolio pertinent to perceived risks conditions.

Furthermore, as we said in Reasons To Distrust Mainstream Economists, some forecasters have different incentives for making publicly based predictions.

Some are there for mere publicity purposes (celebrity guru such as Nouriel Roubini makes the spotlight anew with another wondrous shift by predicting a market meltdown in the 2^nd half! It’s amazing how media glorifies an expert whose calls have been repeatedly off tangent) or to promote certain agenda- e.g. promote political interventions-example Bill Gross [see Poker Bluffing Booby Traps: PIMCO And The PIIGS], sell newsletters, sell funds, etc...

For instance, some experts recently argued that the recent wobbles in Wall Street validates the state of the economy. Does this translate that markets only reflect on reality on when they conform to the directions advocated by these so-called “seers”? That would be utter crock.

The truth is that the current state of the global economy operates under a fiat money regime which perpetuate on the boom bust cycles, irrespective of the actions by regulators to curtail private greed but not on their actions-which have been the underlying cause of it.

Put bluntly, politically oriented boom bust cycles are the dominant and governing themes for both the global markets and the world economy. Therefore, market actions on both directions have been revealing these dynamics.

They don’t essentially validate or invalidate the workings of the economy, because they are `` endogenous effects peculiar to the inner workings of the markets themselves, rather than solely by the exogenous actions of outside events” as Professor Mandelbroit would argue.

Hence, the “desperately seeking normal” school of thought represents as a daft pursuit to resurrect old paradigms under UNSUPPORTIVE conditions- we don’t use radar to locate for submarines or any underwater objects!

Similarly ludicrous is to show comparative charts of the crash of 1929 as a seeming parallel for today’s prospective outcome. This is a brazen example of the cognitive bias known as the “clustering illusions” or seeking patterns where there is none.

Unfortunately, even professionals fall for such lunacy, which is emblematic of why mainstream analysis should be distrusted [see earlier discussion in Why Investor Irrationality Does Not Solely Account For Bubble Cycles].

These people fundamentally forget that 1920s operated on a GOLD STANDARD while today’s world has been on a de facto US dollar standard. Today we have deposit insurance when in 1929 crash we didn’t.

Today is the age of the internet or Web 2.0, where communications have advanced such that they are done by email, or conducted real time as voice mail, web based conferencing, digital cameras, iPods and etc., and where the cost to do business has substantially fallen to near zero and which has, consequently, attracted the scalability of globalization.

In the 1920s, communications were in a primal mode: stamped postal mails, the electrical telegraphs, manual based switchboard rotary telephones, and photography were based on celluloid film 35mm Leitz cameras. All these were emblematic that the 1920s had operated on an agro-industrial age.

Today we have niche or specialized markets when in the 1900s it was all about mass marketing. These are just a few of the major outstanding differences.

In short, the fact that the basic operating framework of the political economy has been disparate implies that the effects to the markets would be equally distinct. Think of it, fundamentally speaking, monetary policies in the pre Bretton Woods 1900s were restricted to the amount of gold held in a country’s reserves while today central banks have unrestrained capacity for currency issuance.

Columbia Business School’s Charles Calomiris makes this very important policy-market response feedback loop differentiation in an interview,

``From 1874 to 1913, there was a lot of globalization. But worldwide there were only 4 big banking crises…From 1978 to now, there have been 140 big banking crises, defined the same way as the earlier ones: total losses of banks in a country equalling or greater than 10% of GDP.” (bold highlights mine)

As you would notice, the emergence and proliferation of central banking coincided with the repeated and stressful occurrences of big banking crisis. Put differently, where central banking fiat currency replaced the gold the standard, banking crisis became a common feature. So to argue that market actions don’t reflect reality translates to a monumental incomprehension or misinterpretation of facts and theory.

Yet if markets should reflect on the same 1929 dynamics, this would be more the mechanics of dumb luck than representative of economic reality. Besides, to presuppose as engaging in “economic” analysis to support such outlandish theories, but without taking to account on these dissimilarities, would also signify as chimerical gibberish or pretentious knowledge.

Bottom line: I’d be careful about heeding on the predictions of the so-called experts, where I would read between the lines of interests of these forecasters, their way of interpreting facts and the theory used, aside from opportunity costs from lapses, and their forthrightness.

Yet, I’d pay heed to Benjamin Graham, the father of value investing when he admonished, ``If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market."