Friday, August 20, 2010

Hindenburg Omen...We'll Wait and See

So yesterday, depending on exactly who's numbers you use, we got either a confirmed Hindenburg observation or a "rounded" one.

When I checked it earlier in the evening, it was clearly "on." The criteria, for those who don't follow it closely, are:

•At least 2.2% of the issues traded on the NYSE in that day must reach new 52 week highs and new 52 week lows. This currently stands at either 69 or 70, depending on the day (it rounds slightly.)

•There cannot be more than twice the number of new lows in new highs. (It is ok for the new lows number to be more than double the new highs, but not the other way around.)

•The 10 week moving average must be positive. It is, right up until today (when the week closes), at which point it won't be any more. (A weekly moving average doesn't change it's signal until the week closes - this has nailed some people with one of my other longer-term signals, the 13/34 WEMA, in the last couple weeks.)

•The McClellan Oscillator must be negative on that day.
If all three occur, we're said to have a Hindenburg Observation. Two or more within 40 days trigger a confirmed Hindenburg Omen.

Note that the Hindenburg is not a warning of an imminent crash, even though every market crash in the modern era has been preceded by one.

However, the probability of a greater than 5% move to the downside (from the date of the confirmation) exceeds 70% within the next 120 days (four months); the odds of a panic selloff (defined as a rapid 10% or greater decline) is about 40%, and the odds of a crash (defined as a 20% or greater rapid decline) is approximately 20%.

There are, however, a couple of flies in the ointment. The first is that the timing of the panic is highly-uncertain. It has occurred as soon as the next day and as far out as four months in the future. In the present case this puts the predicted event anywhere between now and roughly Christmas.

Second, note that while a confirmed Omen has only failed to predict a significant move about 10% of the time, crashes are still relatively rare - that is, it's still about four out of five times that the market does not crash.

For this reason it is best called an "Omen" rather than a "marker" or "predictor."

Then again, when you see a green sky most of the time your home is not destroyed by a tornado. However, most tornadoes are immediately preceded by a green sky.

Put another way, walking to the mailbox this afternoon to get your mail there is a tiny (1 in 100,000 or less) chance that you will be struck by lightning. This is an act you commit daily and think nothing of it.

But if someone was able to tell you that if you went today, there is a 20% chance you will struck dead by a "bolt from the blue", you might think about taking precautions - or waiting until tomorrow.

Thus, this signal tells us that the wise man walks in the market with his shields up for the next few months.

What that means to you will vary. For some people, "shields up" means buying some downside protection - PUTs, for example - as insurance against their portfolio (although yesterday early was the time to be doing that with the VIX up big yesterday.) For others, having ridden the market up from 666 and not wishing to see if Beelzebub is coming to visit once again, it is time to sell. For still others who are extremely aggressive it may be time to get significantly short the market.

Just remember, before doing the short the phone book deal, that there's anywhere from a three in four to four in five chance that a crash will not happen.

But since a market crash is such a life-altering event if you are long the market when it occurs, it is my considered opinion that being unguarded against such a possibility is exceedingly unwise.

This is amplified by the general technical posture. We have a high "fractal" correlation with the last crash in 2008 today (which I've posted a couple of short Youtube videos on) and there is a pattern known as a "head and shoulders top" that also completed yesterday:

That targets 1010. The bad news is that if the target is reached it will confirm the following:

That latter chart is one I've been showing in the nightly videos now for over a month, when it first came into play. I left the price lines and targets alone (so as to deflect criticism that I'm "editing things after the fact".) While the bounce that I expected from under the neckline was longer and stronger than expected, the overhead resistance "warning level" stopped the bounce dead, exactly as I pointed out it should when the pattern first appeared.

This larger pattern is confirmed and targets SPX 880, which by most people's definition will come dangerously close to being a "crash", approaching 20% down from here.

I won't show you the last and most-ominous pattern - but if you pull up a monthly 20 year chart you should see it, given the previous two. No, 880 won't confirm that - we will have to violate the March 2009 lows to confirm that pattern. But if we do...... well, you do the math.