Is This Really the Key to Stock Riches?

Yesterday, a substantial number of investors changed their views about the stock market. But they didn't look to economic news, geopolitical events, or earnings releases to justify their changing opinions. Rather, it took only one thing for them to get a lot more excited about buying stocks: one line moving above another line on a chart.

For market technicians, the big news from yesterday was that the S&P 500 finally underwent what's known as a "golden cross" -- and they see it as good news for shareholders. But can such a simple indicator really give you valuable information about the future?

Market crossing
The idea behind the golden cross and its bearish sibling, the "death cross," is pretty simple. In addition to tracking price movements on charts, market technicians often look at moving averages of those prices over certain periods and how they track over time. Two popular lengths of time over which to calculate moving averages are 50 days and 200 days.

Usually, one of those averages is above the other. But occasionally, the two moving-average lines cross. When it's the 50-day average jumping above the 200-day, you have a golden cross. When the 50-day average crosses below the 200-day, then a death cross occurs.

The conventional technical wisdom is that golden crosses are buying opportunities. But when a death cross happens, you'll be better off getting out of the market.

But it didn't work!
The obvious problem with cross chart patterns is that they don't always work. For instance, we saw a death cross occur just last August, with the S&P 500 trading at about 1170. Although the market did indeed lose ground from there, falling somewhat less than 10% at its October lows, using the death cross as a sell signal would have cost you a lost return of nearly 8% -- not including dividends.

A single failed attempt, though, isn't enough to prove anything wrong. A couple of years ago, Fool contributor Matt Koppenheffer did a much more in-depth look at crosses of various kinds, concluding that the death-cross indicator had been pretty thoroughly debunked by studies looking at contrary results going back to 1955.

Another challenge is that followers of the indicator often hedge their bets. For instance, as Kapitall reported yesterday, relatively weak trading volume has some technical analysts feeling less confident about the bullish impact the cross could have.

But can it make you money?
Most Fool contributors strongly disagree with what I'd call the "strong" theory of technical analysis. The idea that you can look at a chart and predict exactly what will happen without knowing anything about the stock you're looking at runs counter to fundamental investing.

But if you treat signals like this as just one data point among many, it can open your eyes to opportunities you might have otherwise missed. For instance, looking at individual stocks that have recently gone through golden crosses of their own, you'd find:

  • Caterpillar (NYS: CAT) , which has thoroughly tapped into the emerging-market growth story and is poised to continue its success as long as that growth continues.

  • Deere (NYS: DE) , whose agricultural equipment business has enjoyed a huge boom from farm prosperity in the face of high crop prices.

  • Aflac (NYS: AFL) , which has substantially recovered from a devastating turn of events in Japan last year, where it does the bulk of its business.

  • KeyCorp (NYS: KEY) , a regional bank that Fool banking expert Anand Chokkavelu chose for its deep value six months ago -- long before any technical indicator validated his view that the shares fully valued any negative exposure to bad loans.

  • Vulcan Materials (NYS: VMC) , a maker of construction aggregates that has struggled through the U.S. housing and construction slump -- but which smart investors found before it got a hostile bid from industry peer Martin Marietta Materials.

Those stocks are definitely interesting, and if it's a technical indicator that first tips you off to them, then that indicator has some value.

Use the whole toolbox
The problem comes when you convince yourself that any indicator -- whether it's technical, fundamental, or seasonal -- is the only thing to think about when investing. There's no magic formula to stock riches, but when you put the sum total of all your experiences together, that's when you'll have the best chance for investing success.

Earnings season is another example of something worth paying attention to in moderation. In the Fool's "Fourth-Quarter Earnings Report: 7 Stocks You'll Want to Watch," you'll find hard-hitting analysis and information on this quarter's possible big performers. It's completely free for our readers, so click here to access your free report today.

At the time thisarticle was published Fool contributor Dan Caplinger finds both technical analysis and astrology fascinating. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of KeyCorp and Aflac. Motley Fool newsletter services have recommended buying shares of Aflac and Vulcan Materials. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is a lot cheaper than a fortune teller.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.