Sunday, 16 June 2013

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Dear Daily Crux reader,
Longtime readers are familiar with the "Hindenburg Omen." 

The ominously-named indicator was first created in the 1990s, but gained notoriety on Wall Street after predicting the huge stock-market declines of 2007 and 2008. When it occurred again in the summer of 2010, even the mainstream media took notice. Everyone was worried the market would crash.

Of course, the market didn't crash.

Anyone betting heavily on a decline got burned by a powerful year-end rally... And most folks quickly dismissed the indicator as little more than bearish hype.

So it's not surprising that the latest appearances of the "Omen" this month have been largely ignored. But the man who created it – Jim Miekka, editor of The Sudbury Bull and Bear Report – says that could be a big mistake.

He says there are some important differences between what happened in 2010 and today... and the outcome could be very different this time...

Read on for the full details...

Good investing, 

Justin Brill
Managing Editor, The Daily Crux 

www.thedailycrux.com 
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The Daily Crux Sunday Interview 
The Hindenburg Omen:
Why you shouldn't ignore it this time around

The Daily Crux: Jim, the last time we spoke was the fall of 2010. The market had just experienced a few confirmed Hindenburg Omen signals earlier that summer – the first since just before the financial crisis – and the financial media was buzzing.

From The Wall Street Journal and CNBC to the nightly news and political talk shows, it seemed everyone was worried another crash was coming.

But you weren't worried... In fact, you were getting bullish and were looking to buy back into stocks after that summer's selloff. Clearly, that was a good call.

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Now, nearly three years later, we've seen another cluster of confirmed signals, and we're wondering... Should we be concerned, or is this another false alarm like 2010? 

Jim Miekka: Well, there are a few important points to remember about 2010. At the time the signals occurred, we had already experienced the "flash crash" that spring and had another 10%-20% correction that summer. So stocks were already well off their highs.

Sentiment was also quite bearish at that time. In fact, we had more bears than bulls on the Investor's Intelligence survey – my favorite intermediate-term sentiment measure – which is often a bullish contrarian signal.

Third, the McClellan Summation Index – an indicator I've found to give more significance to a confirmed Omen – never fell below the key 1,800 level.

Finally, as you mentioned, everyone was talking about it... which as a contrarian sign, made me skeptical. It's an old rule on Wall Street... When everyone is looking for something to happen, it almost never does.

Today, we do not have those problems.

We've experienced a cluster of five confirmed Hindenburgs over the past few weeks. That's more than we experienced in 2010, and it increases the probability of a valid signal.

This time, the signals occurred while the market was trading at or near all-time highs, rather than after a substantial decline.

Also, the Investor's Intelligence survey has shown 30% bulls over bears for several weeks running, and it actually peaked at 36% shortly before the Omen. Again, this increases the probability of a substantial market decline.

Next, unlike in 2010, this week, the Summation Index dropped below the key 1,800 level.

Finally, and maybe most worrisome, is the level of skepticism I'm seeing toward this year's occurrence.

In 2010, everyone was worried. This time, only a handful of financial writers have mentioned it, and almost all have dismissed it as nonsense. One called it "hot air" and "the worst kind of technical analysis." Another called it "flim-flam"... and said if you believe in the Hindenburg Omen, you shouldn't be allowed to own stocks.

If that isn't skepticism, I don't know what is. And that's exactly what we need to make the indicator come alive. The markets will always do what they can to confound the most people.

So we're entering a very high-risk zone here, in my opinion.

Crux: So you don't think this is 2010... Are you worried this could this be 2007 all over again? 

Jim: In 2007, we had a similar situation in many ways.

The market was at or near all-time highs, as it is now, and we had a cluster of Hindenburgs.

But one thing was different.

As you may recall, the Hindenburg Omen is calculated from three pieces of data from the New York Stock Exchange (NYSE) Composite Index: New 52-week highs and lows, market breadth – a comparison between the number of stocks closing higher and the number closing lower – as measured by the McClellan Oscillator, and the index's moving average.

But you can also calculate the Hindenburg using the NYSE "OCO" – which stands for "operating company only" – data. This is a subset of the NYSE Composite where issues like ETFs and bond funds are stripped out, leaving only the true operating companies.

Without getting too technical, using the OCO data results in different values for new highs and lows and breadth, meaning the Hindenburg can sometimes be confirmed for one but not the other.

I've seen a good historical analysis comparing the Composite and OCO data for previous confirmed Hindenburgs. It confirmed both data sets are predictive of declines, but the average declines were larger when the signal was triggered by the OCO.

This year, we've had five confirmed Hindenburgs using the Composite data, but we've not confirmed it using the OCO data at this time.

In 2007, we had confirmed signals with both the Composite and OCO data.

So I'm taking this year's signals much more seriously than I did in 2010, but I'm not expecting as big a decline as we saw following the 2007 signals.

As I mentioned earlier, I'll be keeping an eye on the McClellan Summation Index for more evidence things could get ugly.

In general, the higher the Summation Index, the harder it is for the market to go down... it's something of a safety net. When it's lower – especially below 1,800, like I mentioned before – the market is more vulnerable. 

What's unusual this time around is that we started at a rather high level. Just a couple weeks ago, the Summation was over 4,500. Usually when it's that high, any correction will exhaust itself before the Summation ever has a chance to fall below 1,800.

But we've fallen from over 4,500 to under 1,800 in just the last two weeks, and it's still going lower. That's an average drop of over 1,000 points per week, or 200 points per day, which is almost unprecedented. That indicates a lot of selling pressure coming on. I would say the fact that we've gotten this oversold and the Summation is coming down this quickly is a sign that we could have some big trouble. 

So I would be very careful right here. We're entering into what could be a potential crash scenario.

Crux: What would have to happen to suggest you're wrong... that this is just another false alarm? 

Jim: If the market started working its way higher from here, and we saw an increase in bearish sentiment – say down to 10% bulls over bears on the Investor's Intelligence survey – that would be an indication that this might be a false alarm. Seeing the McClellan Oscillator turn positive again and the Summation Index rise back above 1,800 would also be a positive sign.

At this time, I don't see that, though.

Crux: Fair enough... Any parting thoughts for our readers? 

Jim: I would just remind you of the old Wall Street adage: Bulls make money, bears make money, but pigs get slaughtered.

Right now, if you're heavily long the market, I think you're being a pig. And you could end up paying the price for that.

In my opinion, the risk-to-reward ratio does not justify being long the stock market at this time. Certainly, I would not be buying new stocks right now. At the very least, if you are long, I would suggest watching your stop losses very closely.

Of course, there are no guarantees in the market. As I like to say, a confirmed Hindenburg Omen is like a funnel cloud. When you see a funnel cloud, it doesn't guarantee you'll get a tornado. Many times you won't. But if you see a funnel cloud, or especially several funnel clouds, it's usually a good idea to take cover until the storm blows over.

Considering how high the market has rallied this year, what the sentiment picture looks like, and how much skepticism there is right now, I think the probability of this Hindenburg Omen actually working is quite good.

Crux: Thank you for talking with us again, Jim.

Jim: You're welcome. Thank you for inviting me.

Editor's note: If you're interested in learning more about Jim's letter, The Sudbury Bull and Bear Report, you can contact him by phone at (727) 866-8682, or by e-mail at dmiekka@cs.com.