Stop Waiting for Capitulation

Everyone wants to know when the latest painful decline in the stock market will end. Yet the answer to that question has virtually no value, compared to the much more important issue behind it: When will markets start to function properly again?

In ordinary times, you can count on the stock market to value shares with some degree of accuracy. Sure, extremes in sentiment -- both optimistic and pessimistic -- are nothing new, and have often sent stock prices moving wildly in one direction or the other. But for the most part, buyers and sellers have the same information about what's going on with companies and the overall economy. They draw their own conclusions and trade accordingly.

Now, however, we're in an information vacuum -- and have been for months. Although we know the government has committed trillions of dollars toward solving the problems in the economy, we know very little about exactly how those problems will get solved. Company news releases no longer seem very credible, the latest example being General Electric's (NYSE:GE) about-face in deciding to cut its dividend -- when its CEO had said hardly a month before that it would maintain its payout.

When investors don't know enough and can't trust what anyone's telling them, it's no wonder they don't want to bid share prices up. When will we get out of this mess?

Some say the world will end in fire...
To call a true bottom, many analysts want to see signs of capitulation -- a final flareout in which the last true believers in the stock market finally admit that they're wrong and sell everything they own for whatever price they can get. Only a dramatic end can mark the market's final low.

Hard as it may be to believe after nearly a 25% drop so far in 2009, those looking for the market's last gasp haven't seen the typical signs they look for. After spiking to record high levels in November, the volatility index has settled back in recent months. And even though the so-called fear index typically rises as stocks fall, it's still more than 35% below where it was in November.

That bodes ill for the future, since the market fell 25% from Nov. 4 to Nov. 20. To send the volatility index back toward its highs, you'd probably have to see a similar short-term drop from February's highs, which would likely require at least a bit more of a drop from here.

...some say in ice.
Other investors believe that a bottom could come without a dramatic capitulation. Since so many are looking for one, what would confound the most people would be a slow, drawn-out process in which investors steadily give up hope of any quick rebound.

Proponents of this theory point to the stunned, almost paralyzed state that many investors are in right now. Having lost so much money and finding themselves in uncharted waters, they don't know what to do -- so they do nothing, and slowly give up interest in the future of their investments.

Based on my own experience in speaking with investors, I think this latter possibility seems more likely. And if it proves true, we might have to suffer through conditions like these for a while.

What to do
But smart investors can still profit. You may be best served sticking with what has worked over the past year: buying reasonably priced defensive stocks that can weather a severe recession. Below are some examples:

Source: Yahoo! Finance.

Eventually, the downturn will end. But waiting for an official announcement that will only come months after the fact is likely only to cost you money. The better course of action is to figure out your strategy now and move forward -- regardless of what comes next.

For more on investing for the long haul, read about:

• Why you shouldn't believe these top 5 financial lies.
• It's time to sell and walk away.
• A tempting trap that could cost you plenty.