Will the death cross kill gold’s bull run?

Chartists have got gold bulls worked up into a real frenzy. They claim that gold has been hit by a death cross' formation. When the same pattern was spotted recently in technology giant Apple's chart, the shares promptly fell by 20%. But can this signal be trusted? And what is charting all about anyway?

There are two basic schools of thought when it comes to investing. Fundamental analysis is about looking at the price of an asset from the bottom up to work out whether it is cheap or expensive. Chart followers, on the other hand, prefer to follow or better still anticipate the crowd.

They argue that markets are largely irrational asset prices can swing up above fundamental value as excitement takes hold, and plunge way below it as fear and panic set in. So the key is to recognise when sentiment has changed towards an asset and act accordingly. Charts help in particular, an analysis of the way moving averages are behaving can reveal a lot about where the market is heading next.

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A quick guide to moving averages

Suppose you take the daily closing price of gold over five days. These are $1,600, $1,540, $1,520, $1,510 and $1,530. The average is $1,540 (the five added up and divided by five). Today, let's say the price closes at $1,510. The new average, using the last five prices, is $1,522 you ignore $1,600 and include $1,510, then recalculate.

The point of a moving average is that it reveals a trend (mildly bearish, since $1,522 is below $1,540), which can be otherwise hidden by daily fluctuations. Clearly, a five-day average is quite short-term. So more commonly used are the 50-day and 200-day moving averages (dma). Chartists will often use these to try to discern turning points in a given market (which can be anything from gold to bonds to corn).

A rising 50-dma cutting up through a falling 200-dma is often a bullish signal. Combined with rising buying volume, for example, it suggests the market is turning up. Equally, if the 50-dma cuts down through a rising 200-dma average it can suggest a bearish turning point has been reached. This is where crosses' come in.

Dark and death crosses

If the 50-dma cuts down through a rising 200-dma you have a dark cross' that's bad as it suggests the 200-day line will also turn down soon. But the really scary combination is a 50-dma cutting down through a falling 200-dma. That's when bulls, faced with a death cross', need to throw in the towel and sell, say the chartists.

The reverse is also true a 50-dma cutting up through a falling 200-dma is quite bullish, but a 50-dma cutting up through a rising 200-dma is mega-bullish a golden cross'. So where are we now for gold?

Since most investors don't own gold directly, US investment expert Barry Ritholtz looked at the popular New York-listed, exchange-traded fund SPDR Gold Trust (NYSE: GLD). As he notes, "since April 2012 we have witnessed the 50-dma crossing above or below the 200-dma on three separate occasions". And what do they tell us? Not a lot, says Ritholtz.

Yes, a death cross flashed on 26 April 2012 and the price duly fell another 7.7% over the next 13 trading sessions. But then we saw a golden cross on 20 September. Yet after that, the price fell 5% within a month. Now we're facing another death cross after a gap of just 100 days, which "hardly provides much confidence as to the acumen of these signals".

A 2010 piece of analysis by Ron Griess at Thechartstore.com looked at every S&P 500 dark and death cross since 1930. Taking the dark crosses, on 16 of 28 occasions the market had risen three months later and also a year later.

For death crosses the three month figure is a slightly better 7/17, but for a year it's 12/17. So it seems that death crosses are a nice way to generate racy headlines, but not so great at predicting what comes next. I wouldn't base a decision to sell either shares or gold on this signal alone.