What Is the Obsession With "Capitulation"?

According to the pundits, the sign that a bear market is ending is a day of capitulation. The trouble is that none of the sustained overall market downturns in recent history have included such an event. When in doubt, let fundamentals guide your decisions, not yet another event that may or may not happen.

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By Bill Mann (TMF Otter)
December 6, 2000

I am always intrigued by the human determination to try to assign meaning and pattern where there is only chaos. Burt Malkiel, author of A Random Walk Down Wall Street, tells an apocryphal story of charting the number of times a coin landed heads or tails. A technical analyst friend of his, seeing the chart, demanded to know what company it was, as he believed that the pattern showed that the company would be up 15 points the next week. This friend did not find it humorous when told that he was not looking at a stock chart at all.

Just as gamblers' hot and cold streaks are not due to any observable cyclical phenomenon, there is no regular force of up or down in the stock market. I don't doubt that there are some technical analysts out there who actually can divine money movements based on the lumbering quality of institutional funds. But, just like it is possible for a snowflake to survive in hell, it's not really the way to bet. The vast majority of all traders -- due to misapplication of some already slippery "rules," or just through the friction of buying and selling stocks caused by taxes, bid/ask spreads, and commissions -- underperform the market. This is, of course, a Foolish mantra, but it has also been observed by some of the leading students of investor psychology, including Terrance Odean and Brad Barber of University of California-Davis.

This article is not meant to be a treatise on technical analysis: If you are using it successfully and beating the market over considerable periods of time, great. I do believe that this is an inefficient and, therefore, more risky way to invest, however. Also, it must be noted that no matter what, technical signs are defined by fundamental events. Stocks do not operate in a vacuum, even if it seems that their prices are completely irrational.

Where some analysts were calling for the Nasdaq to hit 6000 this past March, now it seems that we can't get enough negativity. Who can forget ´┐Żberbull Ralph Acampora's claim that the bull market would continue unabated through 2011, with the Dow Jones Industrial Average hitting more than 100,000. How he even knows what companies will be in the Dow is beyond me. And, for all of the grief that Barron's took for its March story about Internet companies burning through their cash, they didn't turn out to be all that wrong. Each of us has an innate ability to filter out and color it in a way we'd like to see it. Michael Mauboussin quite eloquently described this phenomenon in What Have You Learned in the Last 2 Seconds?, available online at Cap@Columbia (Acrobat Reader required).

We all know the market phenomena ascribed to certain times of the year. There is, of course, dread October -- the month that has seen the majority of great market declines. There is also the January effect, the summer doldrums, the fall rally. Isn't it funny how October, the most nerve-wracking month of the market year, lies right in the middle of the "fall rally" season? How many times this past August did you hear that traders were just waiting for September to start, so the fall rally could get underway? Meanwhile, some of the most volatile stocks have not exactly warmed to the season. A little more than two weeks left in the fall, and Broadcom (Nasdaq: BRCM), Yahoo! (Nasdaq: YHOO), Sycamore Networks (Nasdaq: SCMR), and other fast-moving equities are down 50% or more from their prices on September 1.

This year, investors breathed a sigh of relief to escape October, only to enter into a November buzzsaw, treating us to the worst one-month performance in 13 years. With this in mind, why would anyone expect an "end-of-the-year rally"? There are certain patterns, such as the end of fiscal years and tax years, so some slight patterns do exist, but they are not anything that we should count on. If there were predictable market inefficiencies, they would have been exploited long ago.

There are also certain non-date-specific market terms, many ascribed to technical analysis. The most important in the current scheme of things is "capitulation." The theory behind capitulation is simple: When a stock -- or in this case, a market -- is ready to reverse its course from a long downward trend, it will be marked by a rapid drop in share price, accompanied by massive amounts of selling, culminating in a sharp intraday reversal of price. In other words, capitulation refers to the final flushing out of all of the weak holders of a stock, as large amounts of fresh money enter at a bargain price. Many market pundits are currently saying that, in such a severe drop in the Nasdaq, we will not hit bottom until we endure a capitulation. This is treated as historical fact.

There are a few problems here. First, I believe that we should be speaking of patterns in "the market" only on threat of death. Investors count on the non-systemic advantage provided by individual companies, speculators count on "the market" to bail them out. Secondly, the vaunted capitulation on a market-wide basis is more of a myth than it is historical fact. Maybe it happens on a company-specific basis, but over the last 50 years it hasn't been a part of the landscape signaling the end of bear markets.

Right now, some of you are screaming at your computers that I have forgotten the capitulations of October 1987 and 1998. No, I haven't. There are two issues here. In 1998, we did not have a "capitulation," which would describe a market phenomenon. Rather, on October 8, 1998, the Federal Reserve held a special meeting to announce a rate cut to add liquidity to the market and stave off the economic malaise that had beset much of Asia, Russia, and Latin America. Sure, there was a reversal, but it was not due to people giving up. And, describing 1987 as a "bear market" would be a mistake. In 1987, we saw a rapid shock to the market, followed by a gradual rebound over the next several months. For capitulation to occur, there would have had to be an actual "bear market." There was not in this case, just a rapid, violent contraction of share prices. There is a big difference.

In fact, none of the sustained market declines -- in 1968, 1974, or 1990 -- had a demonstrable culminating point where outsized portions of the market just "gave up," to be followed by a rebound. In most cases, the markets actually showed declining volumes over the duration of the bear market. Rather than capitulation, the proper term might very well have been "exhaustion."

I am sure that there are hundreds, if not thousands, of cases where a company's chart shows evidence of capitulation followed by a strong rebound. But, the current obsessive lookout for a market-wide point of surrender is not supported by past history.

Questions or comments? Pop on over to the Fool on the Hill discussion board.

Finally, I encourage each of you to take a look at the community-selected charities that are a part of Foolanthropy 2000. It's the season for giving, and our Foolish Community has helped identify some wonderful causes.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards