Last week, the most feared technical indicator in all the land was triggered for the second time in less than a month. And that means a nasty stock market crash of 20% (or more) is nigh! At least, that's what the Chicken Little followers of the esoteric Hindenburg Omen want us to believe. I give them credit. They make a compelling argument…
The Hindenburg Omen allegedly predicted every severe stock market drop since 1987. Heck, it flashed a whopping seven times before the S&P 500 cratered 37% in 2008. Plus, the math whiz who invented the Omen – Jim Miekka – recently confessed to being scared stockless. As he told The Wall Street Journal's MoneyBeat blog, "We're on our way down from here. I'm hunkering down for a possible rough ride."
Talk about fear mongering. Should we fall for it and follow suit? Not a chance. And here's why…
Myth-Busting the Hindenburg Omen
For those of you unaware of the Hindenburg Omen (named after the famous German zeppelin that suddenly crashed and burned on May 6, 1937), it attempts to predict a stock market crash by combining five different technical indicators. The list includes the 10-week moving average for the New York Stock Exchange (NYSE), the McClellan Oscillator (a measure of market breadth), and the percentage of new 52-week highs and lows on the NYSE.
The key rationale behind the Omen is that, during normal market conditions, a large number of stocks should either be hitting new highs or new lows. But not both. Followers posit that if a large number of highs and lows were being hit simultaneously, it would signal confusion. And history dictates that investor confusion quickly gives way to panic (i.e. – stock market crashes). Sounds simple and logical enough-- that is, until you actually try to measure such confusion and use it as a predictive tool.
A Calculation As Clear As Mud
Ultimately, if the percentage of securities on the NYSE hitting new highs and lows each day both exceed 2.5%, followers predict that all hell will break loose. But simply exceeding these thresholds isn't enough. To weed out false signals, devotees insist that four concomitant technical indicators need to be triggered at the same time. Then, and only then, can we declare that a Hindenburg Omen is "official."
Oh, yeah… Then there's that bit about one Omen not being enough. Apparently, it takes a second Omen within 36 days of the first to confirm that a stock market crash is imminent. And some contend that it could even take up to five Omens before we have confirmation. Confused yet? Don't worry. Most investors who dig into the Omen this much inevitability get confused, too. The problem is, many mistake the Omen's complexity as being synonymous with credibility and accuracy – when they should be running the other way. Indeed, the Omen is just too darn complicated to be useful or accurate. And the hard data backs me up.
The "Complete" Track Record… and the Mother of All False Signals
Adherents love to trumpet that the Omen flashed before every stock market crash in the last 25 years. Yet few reveal that more than 75% of the time after the Omen is triggered, a sell-off never materializes. And that includes recent history. The last time the Omen flashed was in mid-August of 2010. Instead of crashing mightily, the S&P 500 Index rallied about 25% over the next 11 months.
Miekka swears the Omen didn't work that time because – wait for it – "everybody was watching it." Come on! That's the best you got? At least Zero Hedge's Tyler Durden, an obvious Hindenburg devotee, gives a more plausible explanation. He said the only reason the Omen didn't topple the market in 2010 is because Ben Bernanke announced another round of quantitative easing right around the same time.
Whether you believe the baloney excuses or not, it doesn't matter. Here's the straight truth: At best, the Omen is only right 25% of the time. So we'd be better served flipping a coin each day to decide whether or not to invest in stocks. Oddly enough, that's the case for most technical indicators…
Keep the Fancy Technicals… I'll Cling to the Octogenarian From Omaha
I've always been leery of technical analysis. Forget the complexity – or their ominous and off-putting names, like the "death cross" or the "moving average convergence divergence." I just find it hard to put stock in strategies that turn a blind eye to the underlying business. And with good reason…
As I've shared before, research out of Massey University and Macquarie Capital concludes…
"Technical analysis is not consistently profitable in the 49 countries that comprise the Morgan Stanley Capital Index… We show that over 5,000 [technical] trading rules do not add value beyond what may be expected by chance when used in isolation."
If not technicals, then what? Fundamentals, duh! As octogenarian Warren Buffett famously observed long ago, "If a business does well, the stock eventually follows." Simple as that! In case you forgot, he's used that guiding principle to climb to the No. 2 spot on Forbes' latest list of The World's Richest People.
As for the man behind the Hindenburg Omen – or any other convoluted technical indicator? You guessed it. They don't even show up on Forbes' radar. So technical traders can have their fancy indicators and games of "chance." I'll cling to Buffett and my fundamentals, thank you very much. And, of course, two proven disciplines for mitigating risk – position sizing and trailing stops.
Bottom line: All the chatter – and ominous headlines – about the Hindenburg Omen should be completely ignored. Its clairvoyant infallibility to predict a stock market crash is largely a myth. Or, if you prefer a more blunt assessment, here's what Big Picture blogger extraordinaire, Barry Ritholtz, has to say: The Hindenburg Omen is "a common pick-up line at permabear cocktail parties, good for attracting sexual partners but of little use for anything else."
I couldn't put it better myself if I tried. So I won't.