The word capitulation has seen its popularity rise lately and for good reason. Investor’s anxiousness with the recent market sell-off has skyrocketed, raising the 1 million dollar question: Have we reached a stage of capitulation?
Before we try to answer this question let us first define what market capitulation is. It is the kind of panic selling that builds momentum, causing a dramatic decline in stock prices and taking them to a “bottom.” Capitulation is often associated with extreme levels of fear and selling (volume), bringing the majority of stocks at historically low levels.
One way to look at market capitulation is though the VIX Index. It measures the expected market volatility or market risk and is often referred as the “Fear Index”. There is no doubt that the fear index has increased at levels not seen in the last 4 years but are we experiencing extreme levels? The chart below shows both the VIX and the S&P 500 Index since 2008. VIX has increased by more than 50% from its lows but its levels are not close to those of 2011, 2010 and 2008, when the market dropped by 15% and more.
Market capitulation brings stock prices to historically low levels as more and more investors sell. This creates an opportunity to other investors who are waiting on the side-lines and are ready to swoop in. The price should then, theoretically, reverse or bounce off the lowest price of the stock. We say theoretically because despite the tools we have, it would be impossible to exactly pinpoint the “bottom”. The below chart shows the S&P 500 Index and the % of stocks in the S&P500 that reached their lowest price within a year. The greater the % of stocks at lowest levels, the greater the probability that we have reached a stage of capitulation. Currently that % has increased dramatically but we are still slightly below 2011 levels and way below 2007-2008 levels.
As prices move lower the strength of the trend (momentum) also turns lower and if at extreme low levels then it is possible that we have reached a stage of oversold conditions or in other words, capitulation. One way to measure momentum is by using the Relative Strength Index (RSI). This momentum oscillator has two extreme levels, 70 and 30. Readings above 70 signal very bullish momentum or possibly overbought levels, and readings below 30 signal very bearish momentum or possibly oversold levels. As we are interested in the oversold conditions we have created a chart which shows the % of stocks in the market with momentum readings below 30. When compared with the S&P 500 this gives us an idea of whether market capitulation has been reached. Not surprisingly, the % of stocks at oversold conditions has increased dramatically but again it is below 2011 levels and even 2012 levels when the correction was shallower.
Based on the above we believe that although the US equity market has dropped significantly from its top, there might still be some room for a further correction, possible retesting the previous month’s lows. “Bottom fishing” however is not advised as it is a lose/lose game. What is advised is that investors should have in mind their investment time frame.
As we have pointed out in our July report “US Market on Shaky Ground” http://www.elginamc.com/index.php/the-technical-view-us-stock-market-on-shaky-ground/ things for short and medium term investors are not rosy but long term investors should still stay put as the up-trend is still intact.
Costas Pierides CFTe, MSTA