Sunday, August 15, 2010

The Hindenburg Omen: The Real Thing or Hot Air?

This weekend Zero Hedge reported that on Thursday "the feared" Hindenburg Omen made an appearance.

Wikipedia notes that:
Looking back at historical data, the probability of a move greater than 5% to the downside after a confirmed Hindenburg Omen was 77%, and usually takes place within the next forty-days.
The last Hindenburg Omen occurred during the lows of 2009.

So is the Hindenburg Omen the real thing or hocus pocus? First to the negative, it appears that the discoverer of HO appears to have just ran various empirical back tests. As far as I am concerned, it is  not very impressive to find an indicator via back testing and just running with it. In fact, empirical testing as an investing method generally results in investments that blow up, see Long Term Capital Management and subprime mortgages. That said, I am never against looking at a formula to see if it can be understood in terms of human action, to indeed see if it can show some promise as a solid indicator. So let's take a look at how HO is determined:

The 5 Criteria (Via ZH) That Must be Triggered for an HO moment to be considered activated:

1.The daily number of NYSE new 52 Week Highs and the daily number of new 52 Week Lows must both be greater than 2.2 percent of total NYSE issues traded that day.

2. The smaller of these numbers is greater than or equal to 69 (68.772 is 2.2% of 3126). This is not a rule but more like a checksum. This condition is a function of the 2.2% of the total issues.

3.That the NYSE 10 Week moving average is rising.

4.That the McClellan Oscillator ( a market breadth indicator used to evaluate the rate of money entering or leaving the market and interpretively indicate overbought or oversold conditions of the market)is negative on that same day.

5.That new 52 Week Highs cannot be more than twice the new 52 Week Lows (however it is fine for new 52 Week Lows to be more than double new 52 Week Highs).
I like the #1 factor in the formula. If you have strong activity at both ends, highs and lows, to me this shows as a shifting market, with cross trends--a very good sign of an unstable market.

#2 is a checksum, so nothing to comment about here.

#3 A moving 10 week average indicates the market is high enough for a drop. Obviously, stocks are more likely to fall from high levels than low levels.

#4 This is interesting. The McClellan Oscillator measures cash flow in and out of the market. So if you a negative MO (cash flowing out) but stocks up on a 10 week average, things are getting intense. Stocks higher on less cash is always negative to me as it indicates money is running out to support an advance.

#5 This is also interesting, since in #1 we are detecting movement at both ends. Here we are insuring that a significant part of that new high/new low action is to the downside relative to new highs.

Bottom line: I like this indicator. I wouldn't bet my house on just this indicator, but if you have slowed money supply growth (which we currently have)and this indicator kicks in, things get interesting, since this indicator is really telling you there is significant enough upside action for a major drop, but at the same time something is already causing downside action in other stocks plus cash is leaving the market.

So with the big question being: "Is HO the Real Thing or Hot Air?" I have to go with a mildly enthusiastic, "It's the real thing." I can certainly think of scenarios where these factors could kick-in with an upward moving market, but more often than not, it is signalling what it purports to signal: A very weak upward moving market that is setting up for major downside activity of  5% plus.

I'm  nervous about the market now anyway, but if this indicator is confirmed by another appearance of the HO in the next 65 days, I would be very nervous. It's interesting that there does appear to be some historical data that suggest a reappearance of the HO within 40 days is a strong confirmation of downside activity, since 40 days from now puts us right at the door of October, and I have written before, my theory for the many downturns that seem to occur in October is a spin-off from Austrian Business Cycle Theory. And market crashed do tend to occur in the broader October period:

WSJ's Brett Arends calls the period between Labor Day and Halloween the fright show, and with good reason.

He lists the following stock market crashes that have occurred during this period:
It was, of course, in September last year that Lehman collapsed and everything fell apart.

But then it was also September-October 2002 that the last bear market plunged to its lows.

The 1998 financial crisis? It began late August, and rolled on for two months.

The famous crash of 1987 came in October. But most people have forgotten that the market actually started sliding downhill in late August.

That's almost exactly what happened in 1929 too. The big crash came in October, but the market peaked just after Labor Day. Prices began falling through September, then tumbled further still.

The worst month of the Depression? September, 1931, when the Dow fell about 30 percent.

It was also in September, 2000, that the bear market really got going.

The 9/11 crisis, of course, came in September. That was hardly caused by investors. But what is forgotten is that the stock market was already looking wobbly. In the two weeks before the terrorist attacks, the Standard & Poor's 500-stock index fell 7 percent.

The great panic of 1907? October.

The great crash of 1873? September.

Since 1926, investors have lost nearly one percent on average during September, according to market data tracked by finance professor Kenneth French at Dartmouth's Tuck School of Business. It's the only month with a negative average return.. For each of the other 11 months, investors gained nearly one percent on average

From there Arends can't seem to find an explanation for the fight show down trend. He writes:
As for the causes of a possible September effect, most are stumped.

But there may be an explanation that can be derived from Austrian Business Cycle Theory.

ABCT says that the business cycle is the result of a central bank pumping money into the capital goods sector of an economy away from the consumer goods sector. It is, in other words changing the consumption-savings ratio in favor of savings (i.e. capital goods spending, including stock market purchases). When a central bank stops printing money, the ratio begins to revert to its pre-money printing level. Thus money moves away from the capital goods sector (including the stock market) and towards consumption. Thus, the business cycle and stock market crash--as money is drained from these sectors.

Something of a seasonal ABCT impact occurs every year in the late-August to late-October period that acts like the latter stages (the downside) of the business cycle. Money moves away from the capital goods sector towards the consumption sector, not because of central bank money manipulations but because of natural trends away from savings towards consumption during this period.
August begins the start of seasonal down trend in the market...

It is not an accident that so many stock market crashes occur in October, it is the period of great consumer intensity away from savings and toward consumption. New school clothes, winter clothes and preparation for Thanksgiving and Christmas. From mid-August to December, October is at the vortex of a shift toward consumer buying, away from savings--which includes stock liquidation. A severe crash isn't going to happen without a slowdown in money supply, but the natural tendency for the economy to move in later stage business cycle manner between September and December just adds to the downside pressure during this period. It's just adding more stress to an already stressed economy and stock market.


  1. Robert - how does this fit into your hyperinflation theory? If the stock market tanks, confidence will tank with it (so will net wealth). Is that when the money starts dropping from helicopters?

    If we are staring a market crash in the face, we're going to see asset prices drop before they rise.

  2. My "hyperinflation theory"? I hope I have accurately conveyed the point that Bernanke may be starting on an inflationary road, with an emphasis on "may be."

    It's going to be some time (months) before we see impact in the markets, if indeed the Bernanke money printing has started.

    There's plenty of time for a market drop.

  3. Then disclose your positions Robert. Otherwise, you really don't have any foresight for macro investors here, you're just ranting.

  4. Interesting. September is also the time period when auto companies release their new models for the year. Originally that was why television networks premier new series at this time. The television season was scheduled to coincide with auto season to increase the number of eyes watching commercials. Of course now the auto companies are not the only game in town when it comes to television advertising, but the schedule is already established and other companies follow along. At any rate it does appear that September is consumption season.

  5. this just in: anonymous commenter on an internet blog wants someone who mentions not one single stock to disclose their positions in stocks, because the blog article is about backtesting to pin down the mechanism by which a seasonal phenomenon that everyone recognizes happens.

    i'd write an article about it, but someone would probably anonymously ask me to disclose my sexual preference.

  6. @Anonymous : leaving nothing for the "macro" investor might be exactly the right thing to do. Jackass.

    Purposeful, self-centric, individual, subjective preference - that's what moves the market.

  7. If you're trumpeting hyperinflation, or are highly biased toward that outcome (as Robert is), position disclosure will give you some sense of his judgement over time. I believe his bias will be proven very incorrect.

    Postions can be as simple as 50% cash, 25% US equities, 25% precious metals, etc. They need not be too specific, but they put one's money and track record where their mouth is.

  8. In the old gold standard days panics would often be triggered by the money flows that occurred during the crop harvests.

  9. "Financial Safety Rule #1 says: despite many claims to the contrary, no one, not even your favorite economist or investment advisor, can reliably predict future economic events...."

    Regards, onebornfree.