Stock Exchange: Hindenburg Omen Flashing Red, Is It Reliable?

The Stock Exchange is all about trading. Each week we do the following:

  • Discuss an important issue for traders;
  • highlight several technical trading methods, including current ideas;
  • feature advice from top traders and writers; and,
  • provide a few (minority) reactions from fundamental analysts.

We also have some fun. We welcome comments, links, and ideas to help us improve this resource for traders. If you have some ideas, please join in!

Review: Do You Buy At All-Time Highs?

Our previous Stock Exchange asked the question: Do You Buy At All-Time Highs? The question was meant to be general, but also specific to this year, as the market has made multiple new all-time highs. And if you’ve built up your nest egg in recent years, new market highs can seem nerve wracking, especially with memories of the housing/financial crisis still vivid in many investors’ minds. This week poses a related topic…

This Week: Hindenburg Omen Flashing Red, Is It Reliable? 

The Hindenburg Omen is a technical indicator that compares the number of 52-week highs and lows to predict the likelihood of a market crash. And according to a recent Bloomberg article:

“On both the New York Stock Exchange and the Nasdaq there have been eight of these technical patterns over the past six sessions… the biggest cluster since 2014 and the third-longest stretch in 50 years.”

Jeff offered some perspective on this very topic back in 2010, in this article:

How (not) to Build a Market Indicator: The Hindenburg Omen

For example, here are the key steps to building a trading system or indicator that will look fantastic on paper, but be totally ineffective in practice:

  1. Start with the conclusion. Do not begin by thinking about the problem or generating hypotheses, since those might not work. Instead, look directly at the dependent variable (what you are trying to predict).
  2. Take the result you seek on the dependent variable and run a correlation matrix with hundreds of possible “causes.” This is easy to do with so many technical indicators available. Pure chance results in a correlation when you have so many possibilities.
  3. Find a plausible hypothesis. This is an easy task for smart people. In this article I showed how a group of graduate students at a leading university were tricked by a clever professor. People do not realize how easy it is to find “explanations” when given the answer unless they have had an experience like this.
  4. Start optimizing! Your original relationship will not be perfect. You can make it better by looking at the failing cases and getting rid of them. You can do this by adding new variables to rule out the “bad cases.” You can get really precise with values, specifying a very narrow range that qualify. You can cleverly combine variables.
  5. Use as many variables as needed. This violates a statistical principle about “degrees of freedom” but who cares? The idea is that if you have very few cases and too many variables you are overfitting your model.

After considering how NOT to build a trading model, of course there are multiple RIGHT WAYS to trade, depending on your style and situation. The always outstanding, Dr. Brett Steenbarger, shares one such example in this timely article:

“The holy grail is to have conviction *and* open-mindedness. We can size up a trade at the same time that we intensively review our exit strategy. Aggressive and nimble…just like the sniper.”

We also shared a few ideas two weeks ago in this article:

“If you want to make it as a trader, find a strategy that works for you. That does’t mean never go outside your comfort zone, because it’s important to never stop learning, especially considering the market keeps changing and evolving. But don’t go too far outside your comfort zone because the risks of trading are very real. Keep your expectations realistic. And of course, enjoy the experience along the way!”

Another one of our favorite trading strategies is momentum and trend following. And according to Michael Covel’s recent write-up, he agrees:

We also share a few specific current trades of ours later in this report, but first…

Model Performance:

We are sharing the performance of our proprietary trading models, as our readers have requested, as shown in the following table:

We find that blending a trend-following / momentum model (Athena) with a mean-reversion / dip-buying model (Holmes) provides two strategies, effective in their own right, that are not correlated with each other or with the overall market. By combining the two, we can get more diversity, lower risk, and a smoother string of returns.

For more information about our trading models (and their specific trading processes), click through at the bottom of this post for more information. Also, readers are invited to write to main at newarc dot com for our free, brief description of how we created the Stock Exchange models.

This week’s Stock Exchange is being edited by guest contributor, Blue Harbinger. (Blue Harbinger is a source for independent investment ideas).

Expert Picks From The Models:

Holmes: I purchased shares of Kroger (KR) on 9/13 at $28.75 per share. What do you think about that, Blue Harbinger?

Blue Harbinger: Impressive. I know your style is “dip buying,” and you certainly demonstrated it on this purchase. Kroger sold-off big-time after announcing earnings on Thursday. According to Aaron Back at The Wall Street Journal:

“Kroger is making the right moves to prepare for the future. Investors overreacted to a slightly weak quarter that reflects the costs of those preparations.”

Holmes: That’s nice Kroger is preparing for the future, but my typical holding period is around 6 weeks. I’ll be out of this position before Kroger’s long-term plans play out.

BH: Ok then. I’ll check back with you in 6 weeks. Thanks for the technical trading idea, Holmes. And if any of our readers were considering adding shares of Kroger for the long-term–now may be a good technical entry point. And it’s also good for a quick 6-week trade, according to Holmes, who by the way has a very respectable track record as shown in our earlier performance table.

Road Runner: I recently bought shares of Align Technology (ALGN) on 9/7 for around $369.36.

BH: Because you like the invisalign (teeth straightening) product, or because you believe in the company’s intraoral scanning systems?

RR: I am indifferent about the products. I bought the shares because I am a technical trend follower, and the shares have momentum on their side. More specifically, I like to buy shares in the lower end of a rising channel. You can see what I am talking about in the following chart.

BH: I do see what you are talking about, and I also realize you bought these shares at a low price last week, and you’re already up. Maybe you could give our readers a little more of a heads up next time. You’ll notice Holmes told us about a trade he made very recently.

RR: I do give more of a heads up frequently, but you should also realize the idea is to share the strategy and not just give away trading ideas for people to blindly follow. Learning and understanding are important.

BH: Well for your edification, Road Runner, Align has been consistently growing its revenues and beating earnings expectations, as its products are well received by the market.

However, it’s getting a little expensive on forward valuation metrics such as EV to EBITDA and Price to Sales, for example.

And even though this company spends $100 million per year on consumer marketing programs (e.g. T.V., digital and social media), do you believe the total addressable market is large enough to support the valuations?

RR: Focus, Blue Harbinger. I am a short-term technical trader. I will be out of this trade in 4-weeks. And in case you didn’t notice, I continue to post positive returns which are less correlated with the overall market than many other strategies. Low correlation is a good thing for diversification benefits.

BH: Alright then. I’ll check back with you on this trade in 4-weeks. Thank you for sharing.

Felix: I recently bought shares of Mallinckrodt (MNK) on 9/7 for around $32.99. And to be upfront, Blue Harbinger, my typical holding period is usually around 66-weeks–considerably longer than the other technical trading models. So perhaps we have a little more in common.

BH: Interesting. Thanks for the info. Mallinckrodt is a global specialty pharmaceuticals company, based out of the U.K. Why’d you buy this one, Felix.

Felix: Because I am into momentum, and this stock has plenty of it on its side. For example, it’s sitting above both its 50-Day and 200-Day moving averages.

BH: Thanks for that info. And if you look even further back, you can see these shares were previously much higher, and perhaps the bottom may already be in.

And as you can see in this next chart, short interest is finally coming down for Mallinckrodt. Perhaps the market under-reacted to Mallinckrodt’s non-opioid drug, OFIRMEV, as the trend to reduce opioid use persists.

Felix: Thanks for that info. For your reference, I also ran the Mid Cap 400 through my moidel this week, and the top 20 rankings are included in the following list.

BH: I see World Wrestling Entertainment (WWE) moved from the bottom of your ranking last week to the top this week (although the ranking universe was slightly different last week). I also see MNK ranked in second–makes sense. Thank you.

Oscar: I’ve also got a ranking for you (below). Specifically, I ran our liquid ETF universe through my model, and my top 20 are listed below.

BH: Remind us, what is your methodology?

Oscar: I’m also a momentum trader, and I typically hold for 6-weeks. I generally exit by rotating into a new sector or style ETF.

BH: Thanks. And I see you still like that Direxion Daily Small Cap Bull 3x Shares ETF (TNA), which is ranked at the top of your list. That’s pretty bullish; aren’t you at all concerned about the Hindenburg Omen?

Oscar: My technical trading program was built objectively. I don’t fish for a “fear mongering” indicator every time the market nears all-time highs.

Conclusion

Our trading models use disciplined repeatable processes to make their selections each week, and starting with a “preconceived conclusion–and then working backwards” is never part of their process. The models are objective, by design, to avoid some of the common emotional errors that humans make. The current “Hindenburge Oman” is not part of our process, however we do monitor overall market conditions, and we wouldn’t be placing our trades if we didn’t believe market conditions were conducive to success.

Background On The Stock Exchange:

Each week, Felix and Oscar host a poker game for some of their friends. Since they are all traders, they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check out Background on the Stock Exchange for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am usually the only human present and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.

Stock Exchange Character Guide:

Style Average Holding Period Exit Method Risk Control
Felix NewArc Stocks Momentum 66 weeks Price target Macro and stops
Oscar “Empirical” Sectors Momentum Six weeks Rotation Stops
Athena NewArc Stocks Momentum 17 weeks Price target Stops
Holmes NewArc Stocks Dip-buying Mean reversion Six weeks Price target Macro and stops
RoadRunner NewArc Stocks Stocks at bottom of rising range Four weeks Time Time
Jeff Everything Value Long term Risk signals Recession risk, financial stress, Macro

Getting Updates:

Readers are welcome to suggest individual stocks and/or ETFs to be added to our model lists. We keep a running list of all securities our readers recommend, and we share the results within this weekly “Stock Exchange” series when feasible. Send your ideas to “etf at newarc dot com.” Also, we will share additional information about the models, including test data, with those interested in investing. Suggestions and comments about this weekly “Stock Exchange” report are welcome.

Trade Alongside Jeff Miller: Learn More.

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