August 20, 2006

Hindenburg Omen Nails NASDAQ Stock Market Crash of 2006
by Robert McHugh

Back in April 2006 we wrote warning that a confirmed Hindenburg Omen had occurred, which is a rare event where certain technical analysis criteria line up to give a higher than normal probability of a coming stock market crash. This proved prescient. The NASDAQ 100 reached its Primary degree wave (B) top (a 3.5 year rally) on April 7th, 2006 at 1,750.23. On that very day, we got our first Hindenburg Omen of an eventual 9 observation Omen cluster. The Hindenburg Omen is a warning of a coming stock market crash. On that very day, April 7th, began a 303 point, 17.3 percent stock market crash in the NASDAQ 100. The first wave of that crash finished three months later on July 18th, 2006 at 1,446.77.

So what is a Hindenburg Omen? It is the alignment of several technical factors that measure the underlying condition of the stock market -- specifically the NYSE -- such that the probability that a stock market crash occurs is higher than normal, and the probability of a severe decline is quite high. This Omen has appeared before all of the stock market crashes, or panic events, of the past 21 years. All of them. No panic sell-off occurred over the past 21 years without the presence of a Hindenburg Omen. The way Peter Eliades put it in his Daily Update, September 21, 2005 (Peter is well worth the read, believe me), "The rationale behind the indicator is that, under normal conditions, either a substantial number of stocks establish new annual highs or a large number set new lows -- but not both." When both new highs and new lows are large, "it indicates the market is undergoing a period of extreme divergence -- many stocks establishing new highs and many setting new lows as well. Such divergence is not usually conducive to future rising prices. A healthy market requires some semblance of internal uniformity, and it doesn't matter what direction that uniformity takes. Many new highs and very few lows is obviously bullish, but so is a great many new lows accompanied by few or no new highs. This is the condition that leads to important market bottoms."

The Hindenburg Omen cluster that started on April 7th, 2006 included nine observations, April 7th, 2006, April 10th, April 17th, April 18th, April 24th, April 25th, April 26th, April 27th, and May 11th.

Confirmed Hindenburg Omens are very rare. Including the confirmed Hindenburg Omen we have now, from April/May 2006, there were only 24 confirmed Hindenburg Omen signals over the past 21 years. This is amazing when you consider that during that time span, there were roughly 5,250 trading days. Of those 5,250 trading days where it was possible to generate a Hindenburg Omen, only 168 (3.2 percent) generated one, clustering into 24 confirmed stock market crash signals.

If we define a crash as a 15% decline, of the previous 23 confirmed Hindenburg Omen signals prior to April 10th, 2006's, six (26.1 percent ) were followed by financial system threatening, life-as-weknow-it threatening stock market crashes. Three (13.0 percent) more were followed by stock market selling panics (10% to 14.9% declines). Three more (13.0 percent) resulted in sharp declines (8% to 9.9% drops). Five (21.7 percent) were followed by meaningful declines (5% to 7.9%), four (17.4 percent) saw mild declines (2.0%to 4.9%), and two (8.6 percent) were failures, with subsequent declines of 2.0% or less. Put another way, there is a greater than 25 percent probability that a stock market crash -- the big one -- will occur after we get a confirmed (more than one in a cluster) Hindenburg Omen. There is a 39 percent probability that at least a panic or crash sell-off will occur. There is a 52 percent probability that a sharp decline greater than 8.0 % will occur, and there is a 73.8 percent probability that a stock market decline of at least 5 percent will occur. Only one out of roughly 11.5 times will this signal fail.

All the biggies over the past 21 years were identified by this signal (as defined with our five conditions). It was present and accounted for a few weeks before the stock market crash of 1987, was there three trading days before the mini crash panic of October 1989, showed up at the start of the 1990 recession, warned about trouble a few weeks prior to the L.T.C.M and Asian crises of 1998, announced that all was not right with the world after Y2K, telling us early 2000 was going to see a precipitous decline. The Hindenburg Omen gave us a three month heads-up on 9/11, and told us we would see panic selling into an October 2002 low.

Getting back to the NASDAQ 100 Crash of 2006, a few days after its July 18th bottom, on July 24th, both of our key trend-finder indicators first agreed on "buy" signals, confirming the start of corrective Minor degree wave 2 up. Since those "buy" signals were given, the NDX has risen 6.9 percent. A 50 percent retrace of Minor degree 1 down would take the NDX up to 1,600. Our proprietary Stochastic and Purchasing Power Indicators measure the momentum of supply and demand, and of breadth. We believe the best way to identify a multi-week trend is through momemtum measures. Our key trendfinder indicators are demonstrating amazing accuracy.

But there is more. Not only did the recent Hindenburg Omen warning of the high risk of a stock market crash affect the NASDAQ 100, but we see that the Dow Transportation Average also crashed right after this Omen was given. Since Trannies topped on May 10th at 5,013.66, the day before we got our last Hindenburg Omen, they crashed 878.94 points, or 17.5 percent (we define a crash as a 15 percent plunge over several weeks). They quickly plunged 479 points, or 9.6 percent, over two weeks in May to reach their Micro degree wave 1 bottom at 4,534.63 on May 24th. Trannies' wave {a}-up was a three-wave affair that topped at about the .50 (was .53) retrace of Micro 1-down, up 254 points to 4,789 on June 2nd. Wave {b}-down took Trannies to 4,410 on June 8th. Wave {c}-up of 2 completed a Rising Bearish Wedge termination top pattern on July 3rd, at 4,975.

Since then, we got a decisive break below 4,850, the bottom boundary of the large degree Wedge, confirming that wave 3 down is underway. So far, this wave is 1.75 times the length of 1-down, 841 points, and it looks as if wave 3 wants to be 2.618 times wave 1, a 1,254 point massacre, taking Trannies down to 3,725ish. Wave {1}-down and {2}-up of 3 down are complete. Wave {1}-down ended in a Bullish Declining Wedge at 4,265.50 on August 1st. The wave {2} rally since was brief -- 3 days, topping at 4,560.45 on August 4th. Trannies plunged 425 points, or 9.3 percent, into a wave {i} bottom, the first sub-wave of wave {3} down. This week we have seen a wave {ii} correction.

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"For when the earth experiences Thy judgments
The inhabitants of the world learn righteousness.
Though the wicked is shown favor,
He does not learn righteousness;
He deals unjustly in the land of uprightness,
And does not perceive the majesty of the Lord."
Isaiah 26:9,10

Robert D. McHugh, Jr. Ph.D.
Main Line Investors, Inc.

Robert McHugh Ph.D. is President and CEO of Main Line Investors, Inc., a registered investment advisor in the Commonwealth of Pennsylvania, and can be reached at www.technicalindicatorindex.com. The statements, opinions and analyses presented in this newsletter are provided as a general information and education service only. Opinions, estimates and probabilities expressed herein constitute the judgment of the author as of the date indicated and are subject to change without notice. Nothing contained in this newsletter is intended to be, nor shall it be construed as, investment advice, nor is it to be relied upon in making any investment or other decision. Prior to making any investment decision, you are advised to consult with your broker, investment advisor or other appropriate tax or financial professional to determine the suitability of any investment. Neither Main Line Investors, Inc. nor Robert D. McHugh, Jr., Ph.D. Editor shall be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided.

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