Hindenburg Omen Foretells Coming Market Meltdown

Investors use a variety of data points to assess the likely future course of the market.  Some are WAY out there, such as astrology, sunspots and cycles of the moon.  Others are more traditional like charts, sentiment ratios and overbought/oversold indicators.  Rarely do these types of indicators, which are followed by many, provide much value added.  Most academic studies conclude that the market is a "random walk", meaning that, over the long-term, beating the market is deemed impossible.

For an indicator to even have a chance at being valuable, it must remain somewhat unknown, or understood by very few people.  If it were widely followed, then investors would act on it and it would cease to remain useful.  That's the basis of the "efficient market hypothesis".

One very valuable and arcane indicator goes by the name of "The Hindenburg Omen" (HO). 

What, exactly, is a Hindenburg Omen?   It occurs when several technical factors that indicate certain underlying conditions of the New York Stock Exchange (NYSE) are present simultaneously.  The HO has been present before all of the stock market crashes and/or panics of the past 25 years.  No significant sell-off, during this period, has occurred without the presence of a Hindenburg Omen. 

A Hindenburg Omen is triggered when the daily number of NYSE new 52 Week highs and the daily number of new 52 week lows both exceed 2.2% of all issues traded.   In Tuesday's trading, BOTH new highs and new lows met that criteria. 
 
A brilliant newsletter writer named Robert McHugh, has done a tremendous amount of analysis on this indicator and used statistical analysis to perfect its signals.  According to McHugh, the traditional trigger, to be truly indicative, has several more filters.  These filters include a rising 10-week moving average and negative market breadth, as measured by an index called the McClellan Oscillator.  Both criteria are present today.

Even with these additional filters, the HO has still failed on occasion.  McHugh has developed 2 additonal filters to make the signal deadly accurate.  Condition 4 requires that new 52 week NYSE highs cannot be more than twice new 52 week lows.  However. it is acceptable for new 52 week lows to be more than double the highs.   This was met today.

McHugh's research has determined that there have been 2 incidences where the first 3 conditions existed, but new highs were more than double new lows, and no market decline resulted.

The 5th condition for a Hindenburg Omen to be completely valid is that there must be more than one signal within a 36-day period.  McHugh found 8 instances over the past 25 years where there was just one isolated Hindenburg Omen signal over a 36-day period.  In 7 of the 8, no sharp declines followed.  Most HO's occur in swarms.

But, before we totally follow McHugh off a cliff, be aware that he is also a disciple of Elliot Wave Analysis, a completely useless notion of market movement.  

McHugh also projects that the market is ultimately going to trade to near zero.  Perhaps he's read too many books on 2012!

Tuesday was HO number 1, so a warning flag has been raised.  It is nowhere near a foregone conclusion that a market plunge is imminent.  However, there were other very bad technical signs in Tuesday's trading.

The Russell 2000, a very broad measure of small capitalization stocks, completed an "outside day reversal".  These occur when a stock or index trades above the high of the previous day, reverses and then closes lower than the prior day's low.  These are far from inflammable, as Archie Bunker might say, but tend to be correlated with more movement in the direction of the close.  Since the Russell closed down, we can logically expect more downside imminently, although we don't know how much further the short-term momentum will carry.

The timing of a decline following an HO can begin the day after or as long as 4 months after the signal.  In the current situation, the confirming signal may occur at a lower level.  In fact, market crashes NEVER start from a top.  They generally occur at least 20% lower than the top.  In 1987, for example, the Dow Jones Industrial Average peaked at 2,700 and change.  The crash began with the index a full 20% lower than its peak.  The same can be said for the market crash that occurred during the Great Depression.

So, assuming we've raised your level of concern, what should an investor do with this information?  At the very least, HEDGE!  Take a position in a security that can gain if the rest of your portfolio declines.  This can  be accomplished by purchasing some aggressive inverse ETFs.  My personal favorite is FAZ, a 3x negative play on the financial sector.  If you want to hedge using the Russell 2000, an ETF with the symbol TWM will give you a great play on any downside.

FAZ, which currently trades around $18 per share, traded at $2,000 per share in late 2008!  It has that much leverage.  So, employing one of these, assuming the market melts down, can result in huge gains!  Same goes for TWM.  There are inverse, leveraged ETFs covering nearly every industry and every index.

This is no time for investors to put their heads in the sand.  While the most dire prediction may not come to fruition, ignore this signal at your own investment peril.

Marko's Take

Subsequent to this piece, more information on the HO has emerged.  For an update on this indicator, please click this correction:  http://markostake.blogspot.com/2010/08/hindenburg-omen-all-over-financial.html.