Stocks quoted in this article:
As if the crashing Nikkei and the Tapering Big Ben weren't enough to worry about, here's one more for you: The dreaded Hindenburg Omen has hit! This, from The Wall Street Journal:
Yes, the ominous-sounding technical indicator was tripped on Friday (the second time it flashed in two months), sparking fears about what looms next for the increasingly wobbly stock market. The Dow fell 208 points on Friday, with the bulk of the losses coming in the final trading hour as word of the Hindenburg swept across Wall Street.
For those that need a refresher, the Hindenburg Omen -- named after the 1937 disaster of a German passenger airship -- represents a compilation of trading signals, including 52-week stock levels and moving averages. The thinking is such an indicator flashes during big market rallies, suggesting they have become vulnerable and susceptible to big selloffs.
It was enough to apparently shake 4 billion cicadas out of their 17-year slumber and onto my front lawn. But that's a story for another day.
What is this Hindenburg Omen exactly? Wikipedia has a good description:
The traditional definition requires each condition to occur on the same day. Once the signal has occurred, it is valid for 30 days, and any additional signals given during the 30-day period should be ignored. During the 30 days, the signal is activated whenever the McClellan Oscillator is negative, but deactivated whenever it is positive.
- The daily number of NYSE new 52 week highs and the daily number of new 52 week lows are both greater than or equal to 2.8 percent (this is typically about 84 stocks) of the sum of NYSE issues that advance or decline that day (typically, around 3000). An older version of the indicator used a threshold of 2.5 percent of total issues traded (approximately 80 of 3200 in today's market).
- The NYSE index is greater in value than it was 50 trading days ago. Originally, this was expressed as a rising 10 week moving average, but the new rule is more relevant to the daily data used to look at new highs and lows.
- The McClellan Oscillator is negative on the same day.
- New 52 week highs cannot be more than twice the new 52 week lows (though new 52 week lows may be more than double new highs).
Some users of the omen may choose to view the 30 day limit as "working days" and not "calendar days". This is reasonable as the global finance market works on a weekday (Monday to Friday) scheduleŚleaving about 100 hours where only limited sharemarket trading takes place. This only extends the omen's warning by an extra 10 days, a reasonable limit.
Does it really work? Well, it has apparently called every crash since 1985. It's also apparently called about three times' as many crashes than actually occurred. We're just about run out of time for the crash predicted in April 2013, to name one failure.
This is a very common characteristic of "doom and gloom" predictions. They have a huge ratio of false negatives compared to actual negatives. In our little options world, it's pretty safe to say that all market implosions were accompanied by sizable CBOE Market Volatility Index (VIX) lifts. The problem is that not all sizable VIX lifts accurately predicted market sell-offs. In fact, most of them ultimately become contrarian signals of interim-term market bottoms.
The Hindenburg Omen certainly has sound theoretical footing. It's logical that the diversity of opinion represented by the relatively large number of new highs AND new lows would signal an inflection point. Throw in that we have a market that has rallied on weaker internals, and it all comes together. But there's a possible flaw that the Wikipedia page highlights well:
...the phenomenon may be simply a case of overfitting. That is, by backtesting through a large data set with many different variables, correlations can be found that do not really have predictive significance. The Omen is at best an imperfect technical indicator that is a work in progress.
You see this everywhere. Take football spreads, for example. It's relatively easy to data mine and find criteria that predicted outcomes in the past. Say you found that home underdogs in November vs. division opponents covered the spread 60% of the time since 1980, provided the game-time temperature was below 47 degrees. Have you stumbled on a winning system, or a random coincidence? Most likely it's the latter.
The Hindenburg Omen likely falls somewhere in the middle. It has intuitive logic, but it's always tough to know where coincidence ends and causality begins.
Disclaimer: The views represented on this blog are those of the individual author only, and do not necessarily represent the views of Schaeffer's Investment Research.