Last week's occurrence of a second Hindenburg Omen in as many weeks has investors concerned if an Armageddon scenario is in the cards for the U.S. stock markets.
The Hindenburg Omen is a technical indicator used to foretell the collapse of the American market. The indicator is created by monitoring the number of stocks New York Stock Exchange making a new 52-week highs relative to the number of stocks making new 52-week lows. The omen is confirmed when both numbers are greater than 2.2 percent.
The Hindenburg Omen is specific to the NYSE, and the exact requirements of 2.2 percent often creates an illusion of reliability and has great emotional appeal. However, traders need to question if this type of "exactitude" is a result of a common statistical curve fitting called a "prima donna indicator".
Prima donna indicators, which only perform under very specific circumstances, should not be confused with robust analysis tools. The latter provides reliable results under a variety of conditions and in a variety of markets.
Rather than focusing entirely on the occurrence of the Hindenburg Omen, traders should also take note of a number of other other indicators to forecast the stock market direction. This includes head-and-shoulder reversals that sometimes point to the same conclusion in a variety of markets. The Dow's recent dip below 10200, for example, is the beginning of confirmation of the full head and shoulder pattern.
A look other indicators also showed there were other factors at play which fueled the August 11 selloff. Traders, who have enjoyed Dow's rally from 10,100 to 10,600, would have used many protective stops based on the uptrend line or the support level at 10600, to trade the downtrend the followed. Trend-line stop-selling, in this case, helped accelerate the August 11 fall.
The markets are a chaotic system and constantly throw up relationships that appear to be correlated. A correlated relationship implies a degree of causality. That is, when event A happens it is followed by event B. The more events being measured, the greater the certainty of the conclusions.
Unfortunately, coincidence often mimics correlation. Event A happens, then event B, so the trader assumes a link between the two. Because traders often work with shorter time frames and less data points, the danger of confusing coincidence with correlation is great. Traders should suspect coincidence until correlation is proven beyond reasonable doubt.
Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –www.guppytraders.com. He is a regular guest on CNBC's Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.
If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.
CNBC assumes no responsibility for any losses, damages or liability whatsoever suffered or incurred by any person, resulting from or attributable to the use of the information published on this site. User is using this information at his/her sole risk.