In 1937, the German airship, the Hindenburg, went up in flames and crashed. As you can imagine, the stockmarket phenomenon named after this disaster does not portend good news. The Hindenburg Omen is a ‘charting’ or ‘technical analysis’ pattern that is said to herald a market rout – and it’s appeared on several occasions in the last few weeks. Should you be worried?
How it works
The idea behind technical analysis is that patterns in graphs – such as a share price chart, for example – repeat, and that you don’t need to know anything about the company or market to predict what will happen to the price. We see similar situations arise in markets over and over again, as investors move from extremes of bullishness to bearishness and back again. Technical analysts therefore look for these patterns to try to gauge which way prices are likely to move next.
When the pattern known as the Hindenburg Omen has appeared in the past, say chartists, stock markets have often dipped sharply soon afterwards. Jim Miekka, the former physics teacher and newsletter writer who defined the pattern, recently said: “We’re on our way down from here. I’m hunkering down for a… rough ride.”
The key ingredients
The Hindenburg Omen is one of the more complicated chart patterns – it needs to meet six different criteria. The idea is that if you can spot when investors are becoming more and more uncertain about the direction of the stock market, you can also spot an imminent crash. That’s because once fear over what could happen next hits a certain level, people tend to panic and bail out of stocks.
The key test looks at the number of stocks hitting new 52-week highs or 52-week lows. Trouble looms if this figure is unusually large. Specifically, as Steven Russolillo notes in The Wall Street Journal, the number of stocks hitting highs, and those hitting lows, must be above 2.5% of the total number of stocks being traded that day. That’s about 73 or more each way, based on New York listings.
Last Friday, which is when the Omen was last spotted, there were 156 new lows and 90 new highs, according to Jim Cramer on CNBC, a US news channel. This satisfied another of the criteria: that the number of highs cannot be more than twice the number of lows. This confirms that not only is the market getting more fractured (investors can’t make up their mind which way things are going), but that sentiment is also deteriorating.
Other criteria are market volatility and fear. For example, the ‘McClellan Oscillator’ needs to be negative. Without going into all the details, this indicator tells us whether recent movements in stocks are being driven primarily by a few large stocks or not. In a bull market, this suggests any stock market rise may be about to peter out, as it is not being supported by the majority of shares – in short, the indicator can warn that the rally no longer has ‘breadth’.
Is it reliable?
Charting is more art than science: fans will always claim their patterns work, while critics will point to patchy track records. The Hindenburg Omen certainly isn’t foolproof. In 2010, it created lots of column inches, but the stock market roared ahead regardless.
Veteran investor and Big Picture blogger Barry Ritholtz reckons the indicator has been wrong as much as 75% of the time. However, it did foreshadow drops in the stock market in 1987 and 2008. On balance, with investors fretting over the withdrawal of quantitative easing, we’d certainly advise caution.