Image Credit: LM (Flickr)

Winners and Losers in a Market Capitulation

Capitulation can occur on an individual level, but the term is typically used when so many market participants are giving up on their holdings that the stocks move down as if a bottom has fallen out. The setup for capitulation is in place well in advance of the hours, days, or months that these market events happen. And while, by definition, black swan events are surprises, market capitulation is characterized by a build up, and then a release.

It's also characterized by many questioning themselves and still holding positions and potentially letting a profit turn to a loss.

Capitulate Definition - to surrender often after negotiation of terms           The enemy was forced to capitulate unconditionally. -to cease resisting : ACQUIESCE           The company capitulated to the labor union to avoid a strike.                     -Merriam-Webster Online

Praying to the Gods of Breakeven

It starts after the market has been strong. The market seems to be facing headwinds and investor fears grow. But not by so much that they don’t keep assets in the market. At some point while they were holding, and prices began declining, greed was over taken by fear. That is fear that their positions would never go back up. This fear is then accompanied by hope.

When all hope is lost, investors face what they believe to be reality and finally hit the sell button. They’re often so tired of the painful days that lead them there that they don’t care what the fill price is. This causes the market fall to accelerate, then masses holding positions on margin are also forced to sell. These margin calls help feed the acceleration.

Later, like most financial market behavior, when the last person is done selling, there is only one direction the market can head. Up. While it may go sideways for a while, as recently as last year the market indexes hit all-time highs, this after many market capitulations that came before 2021. So up would seem to be the market’s natural direction long-term.

Seeing it Coming

Markets can come down much faster than they go back up. So taking some risk off the table while the probability of a painful sell-off is increasing is one way to spare yourself of the worst. This is tricky as people often lose more money in lost opportunity than ever lost permanently in the stock market.

Market players tend to begin a bear cycle like a person playing slots at a casino. It takes some money, takes some money, then occasionally pays, which gives the player hope so they stay at in their seat. Participants stay involved because they are occasionally rewarded and they’d prefer not to miss out, and want to regain the small amount they are down.  Investors may also stay involved because they know that out of every single market fall in history, it has always come back and hit new highs.

Pay attention to whether the market is showing technical signs that it may not hold up. Did it easily break through a support level? Is there greater volume on down days then up days? How far past its moving average has it declined?

Fundamental signs are also always worth paying attention to. Is joblessness rising, consumer confidence falling, are taxes being raised, are interest rates making money too tight for businesses to thrive?

If the market you’re involved in is showing either technical signs of weakening or fundamental factors working against it the risks have increased.  

Using it to Your Advantage

Market professionals consider the capitulation phase as reflecting the bottom of the market's price. If investors could identify when capitulation takes place, and exhausts itself fully, they could buy at the bottom. At this point there are no sellers left, only buyers and the market’s bubble has burst and is set to reinflate.

Signs of Nearing Stock Capitulation

Market professionals consider the capitulation phase as reflecting the bottom of a security's or a market's price, and if investors could identify when capitulation has taken place, it would signal the ideal time to buy. This is because everyone who wanted to sell the security has already done so, and only buyers are left.

The problem in identifying capitulation is that it is usually only visible in hindsight rather than in foresight.

Source: Koyfin

The one year chart above shows a slow march downward for 2022 for all S&P sectors except for oil and utilities. While no sector appears to have had the bottom fall out, there are investors whose positions are still well above what they paid for them, and newer positions that may now be at a loss. The longer the downward slide continues, the more likely individuals will give up hope and margin account holders will be called to sell their positions. This increases the likelihood of a short but sharp downward spike.

So far the move downward has been orderly and on a percentage basis not huge, but a real reminder that stocks go both up and down. It certainly doesn’t show that capitulation is imminent or that it has already occurred.

Fundamentally the outlook for stocks is not one of disaster as labor markets are tight, there is a large amount of money in the system the Federal Reserve has not begun to mop up, and company earnings are mixed to strong.

Crypto-Capitulation

Capitulation that occurs in cryptocurrency markets is often stronger than in traditional markets. For example, Bitcoin had a precipitous drop starting on May 2, 2021 when it droppefell from $57,300. to $29,800. by July 17, 2021. This 40% drop was attributed to negative news coming out of China about Bitcoin mining. Capitulation is often more prevalent in speculative assets.

Bottom Line

If seeing capitulation in advance and know when it is exhausted was easy, we’d all be rich. One can act prudently in a few different ways, hedging ones positions using the futures market when they feel risk is increasing is one way. This can be effective both while holding a position and the market seems to be gaining downside momentum, or when the investor believes they have found the bottom but would like to protect any new investment.

It is important to remember that the overall indexes have always grown and reached new highs as the economy continues to expand.

Paul Hoffman

Managing Editor, Channelchek

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