Technicals signal market pyrotechnics

Ignore the Hindenburg Omen. For that matter, disregard the Death Cross and the Bearish Abandoned Baby as well.

These and other technical indicators are pointing to sharp stock market declines at the moment, but investors should be careful about acting on such signals, say advisers.

“Many of the people starting to trade more actively [on these theories] are relatively naïve,” said Will Hepburn, founder of Hepburn Capital Management LLC which manages $32 million in assets, and a former president of the National Association of Active Investment Managers Inc. “They use someone else’s [system] and just apply it blindly.”

Technical signals and theories about what they portend abound on Wall Street. But such signals — which are based on the charting of prices, volume data and other market indicators — often make up in colorful nomenclature what they lack in predictive ability.

The Death Cross, for instance, tracks the market’s moving averages. The Bearish Abandoned Baby is a rare candlestick pattern that indicates a reversal of a market trend. Both are relatively obscure.

JUST HOT AIR?

But the so-called Hindenburg Omen attracted tremendous notoriety earlier this month after The Wall Street Journal reported that the signal, based primarily on the number of new highs and new lows on the New York Stock Exchange, was predicting a market meltdown next month.

“The media seem to focus on these things that I find have no value whatsoever,” said Adam Grimes, director of tactical investments at Waverly Advisors LLC, a research firm. Market gurus can always “find a set of rules that invariably fit history, but have no value going forward,” he said.

In fact, observers of the Hindenburg Omen and similar measures say that once closed-end funds and other non-operating companies are excluded from the universe of stocks, these indicators don’t actually point to the exits.

Besides, the record for the Hindenburg signal is mixed, Ned Davis, president of Ned Davis Research Inc., wrote last Monday in a research note. It gave timely sell signals in October 2007 and June 2008, but it also gave false warnings in 2004, 2005 and 2006, as well as in the 1990s, the firm noted.

The iffy track record aside, “a period with a lot of new highs and new lows is a sign of an unstable tape that often leads to trouble,” Mr. Davis wrote.

Advisers who use technical tools to make tactical investment decisions foresee the market running into more trouble over the next few months. Many were worried when the S&P 500 recently approached 1,050, which they view as the market’s testing of a key support level.

When looking at market performance through a technician’s eyes, a head-and-shoulders chart pattern, with the April highs forming the head, could indicate that the market is rolling over to the downside if the shoulder made at around 1,050 is broached for good, advisers say.

“If it breaks down a little further, and if [the market] doesn’t stabilize, we could be looking at 830” for the S&P 500, based on past support levels, Mr. Hepburn said.

“If the market holds below [1010] for a couple of days, 900 to 950 is the next support” level, said Brian Carruthers, founder of Brian Carruthers & Associates, which manages about $100 million.

The uptrend since March 2009 was broken with the July lows, Mr. Hepburn said. “The rally in July had the potential to re-establish the uptrend — and it failed.”

What’s more, he said, “we’ve got the mother of all double tops,” he said, referring to a negative chart formation formed by the 2000 and 2007 market peaks. “That’s a heckuva topping pattern.”

Other ominous near-term signs, say advisers, are that September and October are often bad months for stocks, as is the second year of a presidential cycle.

“The fact that we’ll have a contentious election means a lot of mud will be thrown, and that unnerves investors,” Mr. Hepburn said. “That by itself can drive down the market.”

NO SURE THING

Of some comfort to technical-analysis skeptics may be the fact that technical analysts often can look at the same data sets and come up with vastly different predictions.

For example, Mr. Carruthers believes the sell-off since April could be a normal correction in a bull market.

“You typically get four to six months of digestion” after a bull market starts, he said. “Since the market peaked at the end of April — four months ago — it would all fit.”

In addition, the advance-decline line of New York Stock Exchange operating companies hit a new high earlier this month, said Mr. Carruthers, noting that such a bullish indicator would not typically appear at the start of a new bear market.

Observers also note that sentiment indicators appear to be bullish.

BEAR TRACKS

The weekly AAII Investor Sentiment Survey, for example, has been showing a growing number of bears among those surveyed — a bullish sign given that this index, which measures the mood of individual investors, is considered a contrarian indicator.

During the week ended May 5, which was near the end of the most recent stock-market rally, AAII bears represented 29% of those polled. For the week ended Aug. 18, after a 6% slide in the market, 42% of AAII members were bearish.

By way of contrast, when the market was approaching its nadir in early March 2009, 70% of AAII members were bearish — confirming the index’s contrarian value since stocks started a strong ascent shortly thereafter.

Since the survey began in 1987, its average bearish reading is 30%.

Sentiment indicators overall are at best a mixed predictive tool, said Jason Goepfert, president of Sundial Capital Research, which tracks measures of investor psychology.

“Sentiment only rarely slides to an extreme, and right now we’re not seeing it” either way, he said.

E-mail Dan Jamieson at [email protected].