The dreaded Hindenburg Omen, which proponents claim foretells a major market collapse, is back according to some market watchers, but fear not as history shows this indicator is full of hot air.
After a number of unsuccessful attempts to call the collapse of U.S. markets, the proponents of this obscure technical indicator are back pedaling analysis methods that give genuine technical analysis a bad name. At its core, this so-called indicator confuses coincidence with correlation.
The Hindenburg Omen is a technical indicator that supposedly foretells the collapse of the American market, but it reveals a more about the behavior of market participants than it does about the market. The indicator is named after the Hindenburg airship which burst into flames in America on May 6, 1937.
The indicator is created by monitoring the number of stocks on the New York Stock Exchange making 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 Index specific to the NYSE with seemingly exact requirements - 2.2 percent. Exactitude creates an illusion of reliability in a world of probability. This type of exactitude is often a result of statistical curve fitting, which signals caution. Specialists indicators only perform under very specific circumstances. Robust analysis tools provide reliable results under a variety of conditions and in a variety of markets.
It's always important to distinguish between something that may be statistically significant and something that is of significance for investors. There's a danger of confusing co-incidence with correlation. And correlations do not always have any significance in terms of prediction.
When this indicator appeared in August 2010 it failed; the market did not collapse. Instead the rose from 10,200 to 12,700, or 24 percent, over the next nine months. The second appearance was in June 2013. Again, rather than collapsing, the market has since risen 48 percent. The Hindenburg Omen has an excellent track record of being 100 percent wrong.
We sort the chaff from the wheat by assessing the Hindenburg Omen against more reliable charting and analysis methods.
The DOW has traded above the upper edge of the long-term up-trending trading channel since April 2014. On the chart, trend line C has acted as a support level, while trend line A is the key long-term support level for this trading channel. The current value is near 15,650 or 13 percent below the Dow's peak. The Dow could fall to 15,650 and still remain in a long-term uptrend. A technical correction with a 10 percent fall in the Dow has a target near 16,192, which is above the long-term support from trend line A. A retreat of 10 percent or 13 percent does not signal the end of the uptrend.
The Dow currently shows no evidence of any end-of-uptrend chart patterns. The chart does not show a rounding top. Unlike 2007, the DOW does not show a head and shoulder trend reversal pattern. These are key patterns that suggest a major change in trend direction.
Many analysts think this indicator is too index specific to be particularly useful. There is little evidence that the methodology can be successfully transferred to other indexes such as the and S&P 500 and this puts this indicator firmly in the camp of co-incidence rather than correlation.
On the other hand, a rise of 24 percent and 48 percent after the two previous false alarms suggests that any rebound from the current retreat may be an excellent buying opportunity.
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 CNBCAsia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.