Thursday, August 26, 2010

How We'll Know If Hindenburg Omen Is Wrong

Yesterday, a 4th dirigible was seen flying the not-so-friendly skies.  According to Robert McHugh, who seems to be THE expert in the now famous Hindenburg Omen, we need 5 to get a "cluster".  But, let's take a deep breath, reduce our hyperventilation, and examine what signs we might look for that would suggest that this entire exercise is nothing but a blip on the radar screen.

One key factor is time.  The "crash window" is open, but won't stay open for very long.  If the financial markets don't implode pretty soon, then this entire exercise will become, as Dee Dee Myers used to say, "non-operational".  Ms Myers, who had the tremendous misfortune of explaining away Mr. Clinton's ongoing non-truths, had to constantly change stories as new facts came to light.  But, we can discuss that at another time.

If the Dow Jones Industrial Average (INDU) remains near or above 10,000 through the end of September, at the LATEST, I'd say that it would be time to go back to the lab. 

Key downside levels to watch would be roughly 9,500 on the INDU, 1,025 on the Standard & Poor's 500 (SPX) and 2,100 on the Nasdaq Composite (IXIC).  A break above 10,500 on the INDU, 1,100 on the SPX or 2,300 on the IXIC would suggest that the markets are probably poised to rally more.

As far as Gold goes, a break above $1,250 would suggest that an upside explosion could be at hand.  Contrarily, a penetration below $1,200 would be bearish, short-term, and probably be followed by a sharp, albeit temporary, correction.

Other signs that this whole scenario is incorrect would include rising long-term interest rates or a falling Dollar.  In the instance of a deflationary scare, we should see a strong dollar and strong bond market.  The key industry group to watch is the financial stocks.  They are currently poised to be leaders on the downside.  The markets CANNOT rally without at least a some upside strength in this group.

Do we care about earnings or economic statistics?  NO!  They are backwards looking and have ZERO predictive value.  In fact, any decline is likely to take place against a backdrop of at least decent news.  Like a sleight-of-hand magician, markets are very expert at having investors look up when investors should be looking down.  Look at my pretty assistant!

It's important to note, that as of this writing, not ONE of these possible contra-indicators is in place.  In fact, there is only one piece of evidence that the scenario is not imminent.  The yield curve is steep and positively sloped, meaning that the difference between long-term rates and short-term rates is high.  The reason this is important is that a steep yield curve creates a very profitable lending environment for banks and other financial institutions which borrow short or cheap and lend long or dear.  Since banks aren't lending, this may not be all that signficant.

The slope of the yield curve determines how profitable the financial sector will be prospectively.  And, as noted above, the health of this sector is important to the direction of markets and the entire global financial system.  It also has very high predictive value in assessing the prospects for economic growth. 

Another sign of strength would be felt in the commodities markets outside of the precious metals, which are acting as currency right now.  Keep an eye on oil, food and key industrial metals such as Copper.  Dr. Copper, as it's known, is a better economist than most Nobel Laureates.  Doc Copper has "Marko's Take" in his waiting room.  As of today, all the commodities are either weak and weakening or looking very toppy.

So, keep on an eye on the checklist that might suggest that the dark clouds are nothing more than a short thunderstorm.  The forecast is for torrential rains, but predicting the market is not much more of a precise science than the weather.  Even if it doesn't rain, don't forget your umbrella.

Therefore, unless the conditions for a re-assessment are met, as described above, investors should continue to hold lots of cash, use inverse ETFs for hedging and profits, and wait out the storm.

Marko's Take

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