Friday, August 13, 2010

Crash and Burn Omen

The pundits and blog writers were abuzz late last week as technical analysts sounded an alarm for the so-called Hindenburg Omen. Technicians claim it has accurately predicted every U.S. stock market crash since 1985. Named after the famed Hindenburg zephyr that crashed and burned in May 1937, the indicator provides an advance warning of a significant downturn in an equity market based on a complex set of technical conditions. These conditions are exacting and are measured daily typically using a certain index such as the NYSE in the U.S. Those conditions must be confirmed by a second occurrence within thirty-six days following the first occurrence for the Hindenburg Omen to be triggered. This confirmation was received last week.

At the base of the Hindenburg Omen conditions is a read on new annual highs and new annual lows among stocks belonging to an index. In the U.S. equity market the NYSE is typically used. There are four criteria that must ALL be met on the same day: 1) both new annual highs and new annual lows number higher than 22.2% of the index total stock members, 2) index moving average is rising, 3) McClellan Oscillator is negative and 4) the 52-week highs number less than two times the number of 52-week lows (the lows can out number highs). A second occurrence within thirty-six days - again all four conditions on the same day - confirms the Hindenburg Omen. (The Wikipedia description is among the best summaries of how the Omen is determined.)

We thought it worthwhile to review how many times in the past the Hindenburg Omen accurately predicted a crash or severe market downturn - and how many times it has been wrong. One of the few in depth reviews was completed by Peter Eliades for the period 1985 to 2005. In the twenty-one years in this period, the Hindenburg Omen was signaled and confirmed twenty-two times.

- In three instances a selling panic occurred.
- A sharp downturn (15% or more) followed six instances.
- In another three instances there were sharp declines.
- Then in five more instances there were meaningful declines.
- Mild declines occurred in three of the twenty-two instances.
- Only two instances were false alarms.

Expressed in probabilities, the 1985 through 2005 track record implies that there is a greater than 25% chance that there will be a crash of some kind following a confirmed Hindenburg Omen. There is a 41% probability of a sell-off and a 77% chance the there will be a decline in the market by 5% or more.

As compelling as the track record might be, the Omen has not been used during the sort of recession-depression period in which we find ourselves these days. Neither has it been used while central government policy makers have been so busy trying to pull the strings on the economic puppet.

Juxtaposing the high and low price groups against each other, the Omen appears to be all least about the state of investor confusion if not the flow of capital. The McClellan Oscillator, one of the four criteria, measures the market breadth and gives a read on the rate of money flowing into and out of stocks in the index. When negative it suggests a bearish market. Unfortunately, the Omen is also untried during a period when corporate and personal cash balances are the current peculiar configuration - i.e. caught up in a deleveraging the likes of which we have not experienced before. That deleveraging has implications for where investors will hold capital.

Our view is that despite how unique we might find our present circumstances, the technical indicator is still probably providing read on whether there is a developing rip current in the regular ebb and flow of the equity market tide. The Omen suggests underlying market conditions that are particularly fertile for “capitulation,” i.e. a loss in confidence in equities altogether and a flight to cash or bonds. Such a loss in confidence could be triggered by an event or disclosure. We all know the third quarter is frequently when the “other shoe” drops.

Is there any harm in holding cash over the next few weeks? It is not likely the U.S. equity market will leave an investor behind if they hold off on making capital commitments to equity.

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