Hindenburg Omen Redux, How Dire Is It Anyway?

By Dian L. Chu, Economic Forecasts & Opinions

The Hindenburg Omen was triggered again last week, as reported by the WSJ MarketBeat. This is the second time this month since its first occurrence on Aug. 12. For those not familiar with the term, the Hindenburg Omen is essentially a combination of four bearish technical indicators on the NYSE occurring on the same day, which would signal increased probability of a stock market crash.

Wall Street is quite abuzz since the Omen seems to have a pretty good track record as Wikipedia documented the probability of greater than 5% downside after a confirmed Hindenburg Omen was 77% within the next forty days. But before everyone goes running for the exit, the probability of a major stock market crash was only 24%, and it would also help to take a closer look at the significance of the Hindenburg Omen itself.

Although Jim Miekka, a blind former physics teacher living in Florida, is said to be the creator, the Hindenburg Omen is largely based on Norman G. Fosback’s High Low Logic Index (HLLI). In an article dated Aug. 24, Mr. Mark Hulbert at MarketWatch recounted a discussion with Mr. Fosback that HILI mainly focuses on the lower of new 52-week highs and new 52-week lows amounted to at least 5%–vs. the 2.5% applied in the Hindenburg Omen–of the sum traded on the NYSE. Fosback believes "this lower cutoff is way too low to be considered bearish."

Another issue, as pointed out by Hulbert, is that the highs and lows numbers are somewhat distorted because many stocks traded on the NYSE are non-operating companies. Hulbert cited findings from Ned Davis Research that excluding non-common stocks on the NYSE, the Hindenburg Omen would not have been tripped, as the new 52-week highs ratio would have been just 0.4% on Aug. 12.

There’s also lack of clear definition as to how many stocks have to reach their highs and/or lows to qualify as the Omen. Other critics believe the Hindenburg Omen may simply be a case of data-mining and overfitting of seemingly random criteria.

My take is that the convergence of several bearish technical signals is a manifestation of the current heightened market risks and volatility stemmed primarily from the economic uncertainty after the global financial crisis, instead of a "leading indicator" for some significant market event. However, since the Hindenburg Omen seems to have many market followers, the typical traders’ “trend trading” could make it into a self-fulfilling prophecy, thus potentially reinforcing the Omen.

So, what should investors do with the second rising of the Hindenburg Omen? The advice from the two creators–Fosback and Miekka—could provide some clues.

According to Hulbert,

"[Fosback] said, his reading of the historical data suggests to him that the current new high/new low data are solidly in the "neutral" category. (Because of other indicators entirely, furthermore, Fosback is quite bullish on the stock market right now.)"

As for Miekka, the WSJ reported that although he thinks there could be a 20% correction into the fall, but he would be buying at a lower price, and may look to short NASDAQ stock index futures "in the next few weeks", depending on the technicals.

For investors with a longer time horizon and balanced portfolio allocation, I don’t believe there’s anything wrong with these strategies.

Dian L. Chu, Aug. 24, 2010