Wednesday, August 18, 2010

Q&A Series - Extra Edition - A Special Series Devoted to Answering Your Burning Financial Questions

Bill, a client and reader of the Rollins Financial Blog, provided the following quote from leading financial media company,

"In case you hadn't heard, Thursday's action on the New York Stock Exchange registered a technical anomaly known as the Hindenburg Omen. Read: just like the doomed German airship, the markets are fated to crash and burn. Still worse, Wednesday's trading action almost sparked Hindenburg Omen conditions. It takes two Hindenburg Omen trading days within a 36 day window to trigger the end of life in the markets as we know it."

Q. What is your take on the significance of the Hindenburg Omen?

There's been a lot of press about the Hindenburg Omen lately. Several other clients asked me this question over the weekend, so I thought I would go on and respond to it now instead of waiting until next Tuesday's Q&A post.

The Hindenburg Omen is a technical indicator that foreshadows not just a bear market, but a stock market crash. Its creator, mathematician Jim Miekka, said his indicator is now predicting a market meltdown in September.

I have never been much of a believer in technical stock market analysis because there are too many variables to give it a whole lot of credence. Most of the well-known theories were created by back-testing the stock market. This means that scenarios were put together and then tested back through time. Analysts would then draw a conclusion based on the formation of the trading patterns. The Hindenburg Omen is such a stock market indicator.

The reason I have never given much credibility to technical analysis is because it only takes into account matters that are happening in the stock during a given time. They rarely take into account external economic events that could have a dramatic effect on trading and be vastly different at any two given points in time.

For example, it doesn't make sense to compare a trading pattern between 1982 when CD's paid 15% interest and 2010 when CD's pay less than 1% interest almost across the board. However, almost every day I see a comparison between the U.S. recession of 1981 and 1982 and the recession in the United States in 2008 and 2009. Given that external economic events were so completely opposite during those time periods, there is no comparing those time periods from a stock market point of view.

For instance, if you could earn a CD rate of 15% annualized or you could buy U.S. Treasury bonds paying 12% interest, there seems to be little incentive to buy anything in the stock market during that timeframe. That was the case in 1981 and 1982. Given that you can earn almost nothing by investing in CD's today, 2008 and 2009 do not seem very comparable to those years.

There are stock market theories for virtually everything. One of the more famous is the Super Bowl stock market indicator. This theory implies that if an original NFL team wins the Super Bowl, then the stock market will be up that year. While this pattern was true for several years, it has not been true in recent years -- but it did have a chance for being 50% correct.

You may have also heard about the January Effect, which basically indicates that if the stock market is up during the month of January, then the entire year will also be up. Once again, this is interesting reading, but it's not particularly accurate.

My favorite stock market technical analysis pattern is the length of women's skirts in Paris fashions. The theory is that the shorter the skirts, the higher the market. I don't need to explain the analogy.

As for the Hindenburg Omen, once again, there is not a clear piece of documentation that it's particularly accurate. It's true that in every major stock market crash, the Hindenburg Omen gave a signal. However, it's also true that there have been many Hindenburg Omen indicators that have not resulted in a stock market crash. The success rate for predicting a market crash with this indicator is only about 25%.

When asked about a Hindenburg Omen causing a market meltdown in September, Andrew Brenner, the managing director at Guggenheim Securities, commented amusingly to his clients, "Personally, it sounds like [people] are starting their weekend drinking early."

While the Hindenburg Omen is fairly technical, it's not that hard to understand. When there are an extreme number of stocks trading at their 52-week high and as many trading at their 52-week low, it causes concern since there is a great misunderstanding about whether the market is going up or going down. More importantly, the 10-week moving average must be rising and the McClellan Oscillator must be negative -- both issues of volatility in a rising market. Even though the Hindenburg Omen flashed last week (incidentally, on Friday the 13th, which perhaps explains the whole frenzy), it has not been confirmed.

There was a lot of publicity on Monday morning when famous, long-term CNBC reporter Art Cashin indicated that the second part of the Hindenburg Omen would play out within three to four weeks. Obviously, no one really has a clue whether or not this will actually happen, but the fact that Cashin made this comment on national television drew some attention.

It's important that we look at the last time the Hindenburg Omen occurred and evaluate its impact on the stock market. The last time there were two confirmed Hindenburg Omens were in June and August of 2008. You may recall that shortly thereafter, the stock market moved up a cool 80%. If the stock market will move up 80%, I'd be happy to have a confirmed Hindenburg Omen today.

So, to answer your question, Bill, I do not give much credence to the Hindenburg Omen. For the reasons above, I'm not sure there's any technical analysis pattern that is any better than another, and none of them in my opinion are very valuable, unless you take into account external economic events. As I have said for many years in my posts, interest rates and earnings are what affect stock market performance; interest rates are incredibly low right now and earnings are incredibly high. The combination of those two positive economic events will almost assuredly lead to higher stock prices in the coming years.

Thanks for your question, Bill. I hope my answer has been helpful to you in evaluating the importance of the Hindenburg Omen.

Best regards,
Joe Rollins

No comments: