The Hindenburg Omen is a technical indicator named after the famous German airship that crashed and burned on landing in New Jersey in May, 1937. The indicator’s purpose is to predict potential stock market crashes, and in the last two weeks, numerous financial blogs are reporting that several Hindenburg Omen trading signals have occurred along with several "non confirmations".

A cluster of Hindenburg Omen signals is generally regarded as being more accurate than one standing alone, and here’s how recent signals look according to Wikipedia.com: (http://en.wikipedia.org/wiki/Hindenburg_omen)

• August 12, 2010: The Omen's creator, Jim Miekka, considered the Omen officially triggered on this date with 92 and 81 new 52-week highs and lows, respectively. The McClellan Oscillator was a negative -120.03 and the 10-week NYSE moving average was rising; the market closed above its open of 50 days prior (May 27). [5]. In the ensuing week, the Omen narrowly missed confirmation twice (August 13 and 19).
• August 20, 2010: According to the Wall Street Journal, the omen was confirmed on Friday, with 83 new 52-week highs and 95 new 52-week lows on the NYSE. The McClellan Oscillator was a negative -106.46 and the 10-week NYSE moving average was rising; the market closed above its open of 50 days prior (June 11). [6]
• August 24, 2010: 166 New Lows, 87 new Highs, McClellan Oscillator was negative, but the 10 week average began to fall. (Non-Confirmation.) (Although the 12 week average is still positive.)
• August 25, 2010: 150 New Lows, 90 new Highs, McClellan Oscillator was negative, but again the 10 week average was falling (Non-Confirmation.) (Although the 12 week average is still positive.)

So, what’s this all about, and should we be worried?

The Hindenburg Omen measures market breadth and overall strength by monitoring the number of securities that reach new 52 week highs compared to those that reach new 52 week lows; when more than 2.2% of securities create new highs and 2.2% create new lows on any given day, a signal is issued. The divergence of new highs to new lows indicates that uncertainty and confusion are in control of the markets and so a significant downturn could be in the offing.

Other elements required for a confirmed observation are:

The New York Stock Exchange 10 Week Moving Average must be rising
• The McClellan Oscillator must be negative

• New 52 Week Highs cannot be more than double the number of new 52 Week Lows

According to Wikipedia.com, "the probability of a move greater than 5% to the downside after a confirmed Hindenburg Omen was 77%, and usually takes place within the next forty days. The probability of a panic sellout was 41% and the probability of a major stock market crash was 24%. Though the Omen does not have a 100% success rate, every NYSE crash since 1985 has been preceded by a Hindenburg Omen. Of the previous 25 confirmed signals only two (8%) have failed to predict at least mild (2.0% to 4.9%) declines."

However, the article goes on to say, "because of the specific and seemingly random nature of the Hindenburg Omen criteria, the phenomenon may be simply a case of overfitting. That is, by backtesting through a large data set with many different variables, correlations can be found that do not really have predictive significance. The Omen is at best an imperfect technical indicator that is a work in progress."

So, statistically, the bottom line here would indicate a high probability of at least a small decline on the Dow, a more than 75% chance of a greater than 5% decline, a 41% probability of a panic sell off and a 24% chance of a panic selloff or crash. All in all, if this Hindenburg Omen adheres to historical patterns, the odds seem to favor downside price action ahead.

So, what should we do? Of course, there can be no one answer to that question since everyone has their own time horizon, their own tolerance for risk and their own investment strategies and goals.

In my work at Wall Street Sector Selector, our primary market indicator is in the "Red Flag" mode, which means that fear is in control of the markets and that we expect lower prices ahead.

I’m not a follower of the Hindenburg Omen, but if it’s correct, and if my indicators are correct, we could be facing continued downside action, particularly with the adverse seasonality that is often seen in the month of September. Possible defensive strategies for such an environment include raising cash, locking in partial profits, buying put options as portfolio insurance or taking positions in ETFs that move inversely to their underlying indexes.

The Wall Street Sector Selector portfolios are currently positioned to take advantage of potential downside action through the use of inverse exchange traded funds, a long position in the VIX, the S&P 500 CBOE Options Index, also known as the "fear gauge" and put option positions.

Whether or not this most recent Hindenburg Omen will prove to be accurate remains to be seen, but with today’s toxic mix of a slowing economy, high unemployment and incredibly negative news in the housing market, it would only be prudent for investors to be on heightened alert for possible dangers ahead.

Disclosure: RWM, SH, EFZ, SEF, PSQ, VXX, SKF, SPY Put Option

John Nyaradi is Publisher of Wall Street Sector Selector, an online newsletter specializing in sector rotation trading using Exchange Traded Funds.

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