Monday, October 18, 2010

The Hindenberg Omen... Really?

By Larry Swedroe

Whenever the financial media begins touting some new indicator for predicting the direction of the stock market, my voicemail and inbox inevitably fills up. The coverage of the Hindenburg Omen was no different. Let’s look a little closer at this indicator.

The basic premise behind the Hindenburg Omen is that it triggers when an unusually high number of NYSE companies reach 52-week highs or lows. (You can read the full list of triggers at the Hindenburg Omen page on Wikipedia.)

The reason for the panic is that it supposedly has been triggered prior to every market crash since 1987. According to one poster on the Bogleheads site: The Omen has appeared before all of the stock market crashes of the past 25 years. The first observation was August 12, and this has been confirmed by a second Omen on Friday, August 20. On July 6, the Death Cross appeared, in which the 50-day moving average crossed below the 200-day. After a brief rally, the market is now again on a downtrend and the 200-day moving average is rolling over. Is anybody getting scared yet?

So when the indicator was triggered twice back in August, it sent the financial media and talking heads into a frenzy. In an interview with Bloomberg,

Albert Edwards of Societe Generale noted that the indicator may suggest “a savage equity downturn is imminent.” He warned investors: “Equities are tottering on the edge as increasingly recessionary data becomes apparent. It would not take much to tip them over that edge.”

Whenever such stories appear, I remember a tale I wrote about in The Only Guide to a Winning Investment Strategy You’ll Ever Need that shows the value of reading charts and interpreting data.

In 1959, Harry Roberts of the University of Chicago created a series of random numbers with a distribution that would match the average weekly price change of the average stock (about 2 percent). Since the numbers were randomly generated, there was no pattern and therefore no knowledge that could be obtained by studying a chart of this nature. To make his charts look like stock charts, Roberts placed a starting price of $40 on each chart.

Roberts asked the leading technical analysts of his day for their advice on whether to buy or sell these unnamed hypothetical stocks. He told them that he didn’t want them to know the name of the stock, since this knowledge might bias them. Each technical analyst had very strong advice on what Roberts should do, but since the numbers were randomly generated, the patterns were only in the minds of the observers. I’m sure you’ll never hear this story from a technical analyst.

Even though the study was published in the March 1959 issue of the Journal of Finance (certainly embarrassing the technical analysis “profession”), you can still observe technical analysts dispensing advice on CNBC. Unfortunately, investors still act on that advice, even though the advice is only good for entertainment. Taken any other way, it’s dangerous to your financial health.

If Roberts’ experiment still isn’t enough to convince you that technical analysis such as the Hindenburg Omen is essentially worthless, consider this. On August 20, the date of the indicator’s key second confirmation, the S&P 500 Index closed at 1,072. On Sept. 20, it closed at 1,143, an increase of 6.6 percent. (This means the S&P 500 jumped almost 70 percent of the index’s annualized return in just a single month.) By end of trading on Sept. 24, the S&P 500 had risen to 1,149, putting the increase at 7.2 percent.

The only thing scary about such omens is that people actually pay attention to the financial equivalent of astrology.

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