How Do You Measure Capitulation?

I Can't Define It, But I Know When I See It

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The beatings will continue until morale improves. (The rate hikes will continue until inflation improves.)

The market continues to get spanked day after day, week after week, month after month. At some point you start to become numb to the daily beatings. Thank you Powell may I have another?

The only thing that continues to matter to the market (and the Fed) is reining in inflation. And so far the Fed appears to be doing a terrible job at it as another inflation print came in last week hotter than expected. It appears they are continuing down their path of demand destruction to no avail.

As reported by CNBC [bold for emphasis]: Minutes from the Fed’s September meeting show that policy makers have been surprised by persistently surging prices, even as they aggressively increase rates to cool off the economy. “Participants commented that recent inflation data generally had come in above expectations and that, correspondingly, inflation was declining more slowly than they had previously been anticipating,” the minutes read. “Several participants noted that, particularly in the current highly uncertain global economic and financial environment, it would be important to calibrate the pace of further policy tightening with the aim of mitigating the risk of significant adverse effects on the economic outlook.

Yes, a soft landing would be preferred by all.

Core inflation is now at 4-decade highs.

I felt something Thursday morning for the first time since the crash of 2020. This panicky, butterflies in stomach, the-world-is-finally-going-to-end type of feeling. I was defeated. I wanted to surrender. Capitulation?

However, if felt different this time. In 2020, the market crash happened so fast if you blinked you missed the bungee jump down to earth and the subsequent bounce back. In contrast, the 2022 bear market has been death by 1,000 cuts. Every time we bounce, the question becomes is it finally the bottom or just another bear market rally? This can do damage to your psyche over the long run, as every rally so far has been denied.

The reason I felt the capitulation vibes was because the hot CPI reading gives the Fed the green light for future raises, which in turn is hurting the odds of me getting a decent mortgage rate before closing (and continuing to completely freeze the housing market). If we could just get some sliver of good news on the inflation front I think the market would at least start stabilizing (read: stop going down). But we are not there yet.

Of course the market instantly sold off in the premarket after the CPI news was released. Bespoke noted in the span of 3 hours, S&P 500 futures had a 3.9% decline and a 3.9% rally. That's not really a sign of a healthy market in my opinion.

There was also this statistic from SentimenTrader:

It got me thinking, as a self-proclaimed seasoned investor who has been through many ups and downs over the years, I know what capitulation feels like. But how do you measure a feeling?

Unfortunately, there is no holy grail, one-size-fits-all, or magic indicator to signal the all clear that the market has bottomed. There's just too much information floating around simultaneously which is what makes investing so difficult.

This week I started reading Scott Nations' book, The Anxious Investor, where he shows that the secrets to excellent investing lie in mastering the quirks of human psychology. Currently, I'm trying to master the fear aspect and make sure I don't succumb to my inherent biases.

I was searching through the book to see if he included any discussion on how he measures capitulation. I didn't find anything so I texted him. Here's his take:

I've always had two conflicting opinions. One, it's like Potter Stewart's definition of pornography; I can't define it but I know when I see it. And two, it's only obvious in retrospect.

To elaborate more on Scott's first point about "I know when I see it", this comes with experience. I remember my first few years of investing it felt like capitulation every time my stocks went down 3-5%. Now, I don't even get out of bed if they're down 30%.

It's not that accepting losses becomes any easier over time, your skin just gets thicker, covered by the calluses of the market swings. You essentially have to George Costanza your own brain to do the opposite of whatever your gut is saying.

The best thing to do in the midst of market turmoil like this is to take a deep breath and embrace an adage that's generally associated with the practice of medicine, "First, do no harm." Regardless of how long it's been since we've had some sort of gut-wrenching, insomnia-inducing market turmoil, one thing will remain constant: when it comes to your portfolio, the most dangerous element during the next stock market crash is likely to be you.

It's also important to note your own capitulation feelings will differ wildly from others depending on variety of factors. For example, if you're near retirement and have most of your money tied up in a 60/40 portfolio (currently having its worst year in 100 years), you may see your future flashing (red) before your eyes. Or say you're one of the youths trading AMC and GME or some crypto shitcoin on leverage. You're subjecting yourself to a ton of volatility. Both of these scenarios are completely different but show how you could capitulate at much different times depending on market forces and your own psychological and emotional fortitude.

On Scott's second point "it's only obvious in retrospect", this is many times the painful truth. You'll either pat yourself on the back for allocating more to your retirement accounts and dollar cost averaging or you'll likely regret your panicked sales when you didn't need the cash anyways. I've been on both ends of the spectrum. At the time of turmoil, it always feels like it's the end. We are just wired to feel this way. A year or two later, you should look back and write down some lessons learned.

Here are a few more ways investors look for capitulation bottoms using a bit more measured approach:

  1. High trading volume accompanying sharp declines, followed by a relief rally or strong reversal. Many thought this happened on Thursday after the CPI report was released but Friday was just another big down day. We haven't taken out the lows yet, so too early to write this one off.

  2. Hammer candles in technical analysis candlestick charting. A hammer is a price pattern in candlestick charting that occurs when a security trades significantly lower than its opening, but rallies within the period to close near the opening price. By the time of market close, buyers absorb selling pressure and push the market price near the opening price. Hammer candlesticks indicate a potential price reversal to the upside. Hammer candles are for people who are also into voodoo and astrology.

  3. Levels of investors' cash holdings (dry powder) and average allocation of money to equities.

4. Large outlier spikes on the VIX. We've essentially been hovering between 20 and 35 for the entire year. A large spike between the 35-50 range could start the capitulation cycle. You can see on the chart below, spikes above 35 have historically marked some pretty major market bottoms.

5. Stocks above/below the 200-day moving average. As you can see below, only 14.5% of stocks in the S&P 500 are above the 200-day moving average. In the past 15 years, only the GFC and Covid Crash had lower levels. The 20% level seems to be an area where buyers start stepping in.

6. Bonus: When a billionaire comes on TV and says "Hell is coming". That's usually a good sign of capitulation.

Based on some of these indicators above, I'm still inclined to believe we haven't hit peak despondency yet. But we're getting closer. The butterflies are moving. Only time will tell.

If you're interested in additional capitulation indicators, scroll through the hundreds of comments in the tweet below: