Sunday, 15 August 2010

STOCKS: Hindenburg Omen confirms dire outlook - crash possible

Last Thursday, a little understood but much commented-upon technical signal known as the Hindenburg Omen appeared, hovering gloomily over market sentiment.  This rare sighting - it has popped up a couple of dozen times in the last quarter century - had financial news reporters all over the world quite agog.   Why?  Its record of alerting investors to major declines and market crashes is frighteningly good...

Simply put, ever since the required data has been available to calculate it, there hasn't been a stock market crash without a Hindenburg Omen appearing first.  

Of the 6400 or so trading days since 1985, this is only the 28th potential signal, yet it has correctly warned of every major market decline during that period. So despite the sneering tone adopted by media hacks (the name of the thing is an open invitation to ridicule), investors with money at risk and any sense shouldn't hesitate to act to protect themselves. 

The indicator works by pinpointing those occasions when, even as the overall market rises, stocks within it are trading at extreme highs and extreme lows simultaneously.  During a healthy market advance, most stocks will be steadily moving up and posting yearly highs, with very few posting yearly lows.  But eventually the number of new lows rises as investors sell underperforming stocks and gravitate towards winners; the winners can only carry the whole index for a while and so at some point instability sets in and the overall market finally topples over.

The last cluster of occurences came in 2007 and 2008, and were, you might say, rather timely:

Here is the latest Omen:

New yearly lows (red) and highs (green) both exceed 
2.2% of all stocks simultaneously

The probability of a decline greater than 5% occuring after this signal is approximately 80%, with 30% of signals since 1985 having appeared before a major market crash.  So disaster is by no means certain, but it is more likely than would randomly be the case by several orders of magnitude.  Are your investments positioned for this possibility?

History suggests that seeing more than one Omen within a 36 day period creates a more reliable signal.  I will of course be scanning the horizon for that, but the ominous Hindenburg is far from being the only reason you should brace for a further decline.


With every one of my eleven daily indicators having turned south, I've been waiting for the majority of their longer term brethren to join them before setting up any new trades.  This weekend, of the nine weekly indicators, six are now on sell signals, three are neutral and zero are on a buy.  With the benchmark S&P500 index currently struggling under its 200-day moving average, this is an unambiguous flashing red light.

Here are some of the most revealing charts I'm looking at:

1.  Risk Aversion Indicator suggests a very large move is building - and it sure doesn't look like it's up

The value of the Semiconductor Index divided by the Japanese Yen is as good a proxy as I've found for extremes of risk appetite and risk aversion.  It has identified all major turning points since the early 1980s. The line plunging below its moving averages is a clear indication of investors' readiness to flee stocks.  Not only that, but the sudden huge drop off in volatility is alarming - like the proverbial lull in a storm, a contraction in volatilty is always followed by expansion; major moves in stocks naturally follow.

2.  Sentiment tide turning in speculative options 

Speculative fever hit its peak in April this year as traders bought more than twice as many call as put options (ie. twice the number of bets the market would rise than fall) - a contrary signal straight from the heavens.  Once the last buyer was in, the stock market (in gray) tanked and has struggled despite this indicator hitting its opposite extreme and giving a buy signal in May and July.  This lack of response is a tell that the longer term trend may have changed.  The latest cross above the 21day moving avg occured last week.

3.  The US Dollar is surging as fear makes a comeback

Since the start of the crisis in 2007 the dollar (red) has shown an increasingly negative correlation with the stock market.  A rise in the dollar has tended to mean one thing: investors are cashing out of the weaker currencies and riskier assets (stocks included) and seeking safety in the bosom of Uncle Sam.  The dollar has become the last refuge of the bewildered trader.  A cross above its 14 day moving average has generally signalled tough sledging ahead for the stock market.

4.  Internal market strength is deteriorating

Before an index itself rolls over, there is commonly a gradual weakening in the number of stocks showing strength.  This chart shows the number of stocks in the S&P500 trading above their 200-day moving average.  If a stock can't hang on to its long-term moving average it's in trouble and eventually the same will apply to the market in general.  

The same type of vertiginous plunge in this indicator occured in April as it did in July 2007, and it has been one of the most accurate ever since at getting watchful investors in and out at just the right times.  It renewed its sell signal last week.

5.  Bond market signalling deflation, leading stocks lower

The bond market has been sniffing deflation since even before the crisis began back in '07.  That kind of environment is bad for stocks but great for bonds, since you get a relatively high and fixed rate of return - which makes your bonds become more valuable as inflation and other asset prices fall.  

While stocks drifted lower in late '07, bond yields plunged, as investors rushed to lock in a safe return (when bonds are bought prices rise as yields fall).  We seem to be looking at a re-run today, even with US 10-year treasury rates at a miserly 2.7%.  

There certainly seems to be a disconnect between stock investors who, having pushed prices up 70% in 18months are determined to see the glass half full and bond traders, who are busy rushing to safety in expectation of deflation and low growth as far out as the eye can see.  Eventually, stocks must fall or yields must rise, or some combination of both; but history suggests that when this kind of divergance opens up, bond markets are usually right.


I could go on but the rest is variations on a theme, I'm afraid.  The market is set up for a fall which could, if conditions conspire, turn into something pretty dramatic.  

Timing it perfectly is going to be tricky - techncial clues suggest a brief bounce may now occur which lasts anything between a couple of days and a couple of weeks. Should we get that I'll be using it to build a substantial short position.  Or weekend news could kibosh that hope and we might just plummet from here, starting Monday.  I'm also not ruling out the possibility that we fall hard then suddenly reverse when we hit the lows set in June or July.  

Whichever, it's time to put on your tin hat, Wolfgang and prepare to take enemy fire.  If you're still heavily in stocks and have no hedging strategy, I'd suggest instituting such a strategy immediately or lightening up substantially on your holdings.

If your stock positions are held opaquely in a pension plan, I'd call your provider immediately to switch into the safest category or risk profile they offer, one which is predominently in cash (ideally) and/or in bonds.

All in all, friends, I think we're finally on the verge of the re-adjustment I've been writing about here for so long.  As it plays out, watch for essential updates in this space as the drama unfolds.