Often, at or near market tops, technical indicators converge or line up, adding considerable weight to the predictive value of these stock market directional indicators. While the historical accuracy of many individual indicators is questionable, when several of the more consistently reliable indicators “fire” at the same time, we should take note.
Before we discuss the specifics of the key indicators that are currently predicting a correction, I would like to warn readers that the following commentary will be a bit data heavy. I apologize in advance for this, and will do my best to keep the market-speak (complicated financial vocabulary) to a minimum. I would also like to mention that I do not place great significance on any single technical or fundamental indicator. I watch everything, and weight all data and information as appropriately as possible, within the context of the current investing environment. When multiple indicators signal the same outcome, however, I pay close attention.
One of the most formidable challenges that wealth management professionals face is making sense of the depth and breadth of information constantly flowing from the fast-paced trading environment in the global financial markets. For this reason, we try to focus on those indicators that have been consistently accurate over time, and in diverse market conditions. In my experience, some of the indicators that are the simplest and easiest to understand are the most reliable and accurate. Simple moving averages have proven to be highly predictive. Typically, market indices will trade above or below moving averages, such as the 50-day, 100-day and 200-day. A moving average simply takes the number of trading days in the average, adds them up and then divides by the number of days. For the 50-day moving average, we would take the most recent 50 days' closes for the index, add them and then divide by 50. Each day the calculation is repeated and the results are plotted as a graph.
In the graph below, we see the Standard & Poor's 500 Index with the 50-day moving average superimposed. It is clear to see that the S&P 500 has bounced off of its 50-day moving average multiple times over the past nine months, going back to December 2012, only penetrating below it once in June (after stocks set the May 22 all-time high). The trading action of this index in relation to its 50-day moving average indicates that the 50-day moving average is a highly predictive indicator for the S&P 500.
At present, the S&P 500 is sitting on its 50-day moving average. This is an inflection point for the index — it will either bounce off of its 50-day moving average, or it will penetrate it and trade significantly lower. Given the recent rally in stocks from the November 2012 lows, the magnitude of the rally — a 26 percent-plus gain, and current valuations — a 19 price/earnings ratio, which is very high, a break through the 50-day moving average should result in a substantial drop in stocks.
The graph above shows the S&P 500 with its 50-day, 100-day and 200-day moving averages (top to bottom). Historically, when these bunch up together, we usually see the market move significantly in one direction or the other, up or down. The 100-day and 50-day got very close to one another in November 2012, which was the most recent significant bottom before the 26 percent rally we have experienced since that low. We can see that the 100-day and 50-day are getting very close again. Combined with the other indicators, this could indicate a pending break to the downside.
The Hindenburg Omen is an interesting technical indicator, despite its dramatic name. This indicator predicts market crashes with a reasonable level of accuracy, and is named after the Hindenburg disaster — the 1937 explosion of the airship in Lakehurst, N.J.
The Hindenburg Omen predicts market corrections or crashes, and has predicted every major correction or crash over the past 30 years. It is based on the number of new 52-week highs and 52-week lows set by stocks when a market is making new highs. If the total number of new highs is less than the new lows, and both new highs and new lows are in excess of 2.2 percent, or about 76, of the total number of stocks (about 1,700 on the New York Stock Exchange), then the Hindenburg Omen is activated.
The table above shows the new highs and new lows over the past 12 trading sessions. I have been closely watching these data and see reasons for concern. I have highlighted the days during which the Hindenburg Omen was indicated — three days in the past 12 trading sessions. More concerning is that the past two trading sessions show new lows that are at least 10 times the new highs (more than 20 times for last Thursday, and more than 10 times for last Friday). We would expect to see the opposite — new highs outpacing new lows — in a healthy market that is making new highs, much less new all-time highs.
Any single indicator can be dismissed and often when technical indicators fire independently, they mean little. However, when multiple indicators fire simultaneously, prudent investors take note and take action.