Golden Cross in the Dow-Jones Industrial Average

Something fairly rare has occurred in the Dow-Jones Industrial Average (DJIA) over the past few days: the 50-day moving average crossed above the 200-day moving average. This is referred to as a "Golden Cross." The chart below shows this (click to enlarge):

To many, this signifies a major buy signal for the stock market. Indeed, if you look at history, when this occurs, generally the market does fairly well for the next several months. Is that likely to be the case this time?

Over the past few years, the stock market has allowed patterns such as this to emerge. But, instead of potential investors being patient and waiting for further confirmation before entering the market or expanding their positions, they have all too often jumped in enthusiastically. What has the market done? It has caused the pattern to either reverse of be eliminated, stranding those poor (now literally) souls who impatiently dove into the market and committed their funds.

This happened about a year ago, when a head and shoulders pattern formed in the S&P 500. Before waiting for confirmation (price must fall below the "neckline"), it seems that just about everyone jumped in to short the market or obtain options that work the same way (puts). When the pattern failed to materialize, many were caught on the wrong side of the market (short the market). In a panic, there was an attempt at a mass reversal of direction, leading to a major rally for several months!

Let's get back to the chart. Yes, there has been a Golden Cross. BUT, note that the DJIA is in slightly overbought territory (i.e., the RSI > 70) AND at its current level, the market is not far from a resistance level. Put this all together and it is not clear that the Golden Cross will be sustained in the short-term. If resistance holds, those who have recently jumped into the market will not be happy.

Now let's shift gears and inject economics into this. In addition to the technical analysis I just covered to evaluate whether the DJIA is likely to go above resistance, use economic theory:

DJIA = f(short-term interest rates, profit expectations)

(this was covered in the most recent set of notes). Short-term rates, related to asset substitution, are likely to fall a bit more, but they are already very low. So, don't expect much change from this component. Focus instead on profit expectations.

For the DJIA to break above resistance, it is necessary for profit expectations to be elevated above their current levels. QE2 (possible upcoming quantitative easing) has already been priced in. So, if that fails to materialize, stock prices will fall and much of this last leg up will likely be lost. Earnings results are beginning to be reported. If those are very good, better than expected, resistance may well be broken, as long as two things occur. First, top line (revenue) growth has to be emerging with greater regularity than it has in the past. Second, earnings guidance (what they expect to occur in future quarters) cannot be disappointing.

Then there is the election. The stock market will very likely react positively to the expected increase in the number of Republicans in the House and Senate. But I expect this to only be a short-term rally. Gridlock will occur, as governing will more closely resemble the WWE than what we studied in Civics class. Historically, gridlock favors bonds over stocks. Beyond this, the desire to move toward smaller budget deficits will hinder economic momentum over the short-term.

So, at this point, it will be interesting to see how all of this plays out. I do expect a short-term rally after the election, before the market returns to fundamentals as next year begins. While it is quite possible that the Golden Cross will hold for a few months, I expect this to be a shorter period of positive upward momentum that prior crosses have produced.