The Hindenburg Omen, A Potential Fat Tail Event on the Horizon?

By: David_Urban

The S&P 500 has been flashing a number of technical signals to the market over the month of August.  Amongst the various signal we had an inverse head and shoulders and an ascending wedge giving investors bullish and bearish signals.  August 11th provided a resolution with the ascending wedge breaking down and the market moving significantly lower.  More troublesome was the market's action the next three trading days.  After large moves in one direction the market typically consolidates in the opposite direction as short term traders look to book profits and others buy on dips/sell into strength.  What we had was the opposite, a market that could not move higher and instead drifted lower. 

On August 12th, a Hindenburg Omen signal was triggered.  A Hindenburg Omen is a statistical sign made up of market indicators which foreshadows a move to the downside.  Just one Hindenburg Omen is not enough as there needs to be confirmation of the first signal within 36 days.  If this signal is not confirmed then the signal is not valid.

The Hindenburg Omen has 5 criteria which must be met. 

1. The NYSE 10 Week moving average is rising.
2. The McClellan Oscillator is negative on that same day.
3. The new 52 Week Highs cannot be more than twice the new 52 Week Lows (however it is fine for 52 Week Lows to be more than double new 52 Week Highs.)  This is a mandatory condition.
4. 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 with
5. The smaller of the two numbers being greater than or equal to 69.

Delving into these criteria what we find is an indicator which attempts to signal the possible occurrence of a fat tail event.

First, we have a rising NYSE 10 Week moving average which suggests a market trending upward followed up by a fair portion of stocks making new highs.

But underneath the surface there is trouble.  The McClellan Oscillator, used by traders to gauge market breadth, is negative signaling that more stocks are falling than rising.  This is a sign that a correction may be approaching. 

Next we have the 52 Week Highs and Lows.  In an rising market one would expect significantly more new 52 Week Highs than new 52 Week Lows.  But here the number of new 52 Week Lows are close to the number of 52 Week Highs, relatively speaking. 

The number of 52 Week Lows are also more than 2.2% of the total NYSE issues traded that day.  This sends a signal that the 52 Week Lows tail is getting fatter, a sign of underlying weakness.

What we find is that while the market appears calm, there is significant turmoil and weakness underneath the surface.

While a Hindenburg Omen does not mean the market will crash it is a signal that a fat tail event may be approaching in terms of a market pullback.

Thursday and Friday of last week provided a confirmation of the original signal.  According to the Hindenburg Omen there should be a move to the downside in the next 40 days. 

This does not mean there will be a crash.  The downside move could only be as small as 5.5% for the signal to be accurate.

It is not my belief that we are heading for a second stock market crash but investors should tighten stops on long positions and/or hedge long positions until the danger passes. 

The underlying market weakness following the markets drop on August 11th combined with weak economic reports should give investors pause.  The inability of the market to move higher indicates a lack of buyers as investors seem to be waiting on the sidelines. 

Now there is good news to report.  This drop, should it occur, would put in a major low for the four year Presidential cycle leading to a solid rally into 2011.  In other words, protect your long positions and get your cash ready to allocate so you can buy at the bottom.

By David Urban

http://dcurb.wordpress.com/

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