Investor Capitulation, Part 2

“The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.” – Warren Buffet.

In a previous post, I raised the possibility that we might witness a kind of panic selling called capitulation. This was not meant to be a prediction. It was an observation that sometimes a bear market ends in a very sharp decline, and it is generally associated with investors’ extreme discouragement and/or disgust. This is not an exact science, but more like Justice Potter Stewart’s comment on pornography – you’ll know it when you see it.

Well at 7:30 this morning, the futures markets indicate a very weak opening for U.S. stocks. This is happening after markets had steep declines in Asia, with the Japanese stock market falling almost 10%. European stocks have also declined by 7-10%. Right now it looks like we are going to have a “Terrible, Horrible, No Good, Very Bad Day.” (Judith Viorst) Of course, no one knows where the market will close today or what will happen next week.

For more context, Mark Hulbert’s column Anatomy of a Bottom, written for MarketWatch on October 21st, describes the difference between a “Panic” and “Capitulation.”

Capitulation has a number of distinguishing psychological characteristics, such as investor disgust and exhaustion. Having been burned by the market for so long, investors capitulate by resolving never, ever, to trust the market again.

In the wake of capitulation, therefore, interest in the market declines. Apathy rules.

To be sure, this definition cannot be mechanically measured. It is hard to pinpoint when investors become maximally dejected and apathetic. But my hunch is that we have yet to experience capitulation.

One illustration of capitulation that I find particularly instructive, even though it is from a pre-Internet era: During bull markets, as well as during bear markets up until capitulation finally occurs, investors turn to the business sections of their morning newspapers to see how much they made or lost the previous day. At times of capitulation, in contrast, investors don’t even bother to open the business section at all.

From the perspective of this illustration as well, capitulation is yet to occur: Far from being ignored, business news is now splashed all over the front pages of newspapers’ lead sections.

My guess is that, when that low does finally occur, we’ll be witnessing, and experiencing ourselves, a lot more of the psychological traits associated with capitulation: Exhaustion, disgust, lack of interest, even apathy.

Interpretation and Advice

Investors, by definition, are “in it for the long run.” If the recent events on Wall Street, and indeed, across the globe, have you so discouraged that you question whether stocks really do provide higher returns than bank CDs, then you are in the grips of capitulation. How you behave or how you react, at this moment, will be what determines your rate of return for a long time to come.

If you sell when everyone else is selling, you may get some immediate psychological comfort that you have come in out of the storm. My belief, which is based on extensive experience, is that you will do yourself harm in the long run.

What happens to stock prices in the short term is anyone’s guess, but if investors are not rewarded for taking risk by investing in stocks, capitalism cannot function.

photo credit: JdeePanIII

Investor Capitulation, Part 1

“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” – Warren Buffett.

I do not believe in the concept of market timing, because no one knows what the short term direction of the stock market will be. An educated guess is about the best anyone can make. That is why a buy and hold strategy, using a well diversified portfolio, works best for most investors.

Given their own, sometimes naïve, perceptions, investors can become either too optimistic or too pessimistic. Unfortunately, it is typically easier to identify these times after the fact.

It is very easy to make predictions that turn out wrong, even if you are very knowledgeable.

For example, former Federal Reserve Chairman Alan Greenspan warned about “irrational exuberance” in 1996. He clearly thought that the high stock prices of 1996 could not be justified. Nevertheless, the stock market went up in 1996, 1997, 1998 and 1999. Eventually, in March of 2000, stock prices began their steep decline. Needless to say, if you had heeded “Financial Guru” Greenspan’s warning in 1996, you would have lost out on 3 – 4 years of profitable gains.

In October 2002, after stock prices had fallen almost 50% from their previous highs, a lot of investors “threw in the towel” and basically gave up on stocks. They sold their holdings and stayed out of the stock market for several years. Many of those investors compounded their mistake by switching from equity mutual funds to variable annuities. (That is a topic for another post.)

Let’s assume that, right now, given the current economic climate, the majority of investors are pretty pessimistic about the future. How can we tell? There have been plenty of indicators. Stock prices have already declined more than 35% from their year-ago highs. Banks have been afraid to lend to each other. Institutional investors (pensions, university endowments) have been pulling massive amounts of money out of hedge funds. Many individual investors have been heavily selling mutual funds. And many people, and institutions, have flocked to short-term Treasury securities,  because they are known to be extremely safe investments, albeit very low yielding ones.

Now, suppose stock prices continue to fall, resulting in investors becoming even more pessimistic than they already are. How could this happen? Well, what if so many investors decided to redeem their accounts that hedge funds needed to sell off even larger amounts of stocks, bonds, and commodities just to fulfill the investors’ demands. What if individual investors continued to sell their stocks and mutual funds, only doing it in greater amounts and with far more urgency?

Panic Versus Capitulation

What is this called? Well, panic is one term. Capitulation would be another. You may be hearing this particular term more often now. What would capitulation look like? Probably like the end of the world. The Dow Jones Industrial Average would fall by 800 – 1,000 points or more in a single day. And just suppose that that the selloff continued for a second day. Imagine the ominous discussion on TV. Investors would feel discouraged, disgusted and positively sick. One reaction might be, “Get me out now, at any price!”

If that happens, and there are certainly no assurances that it won’t, then this may in fact be the best possible time to buy more stock. Of course, it is very difficult to even consider buying when prices are actually plummeting and everyone is afraid. (You should note that it is incorrect to say that there are “more sellers than buyers.” In point of fact, there is a buyer for every seller, or more aptly put, each share to be sold will be bought. It is just that the sellers are willing to accept lower stock prices than previously was the case.)

I do not know if the capitulation phase of the bear market will occur. In Prepare for the Revulsion Stage  Janice Dorn, Chief Global Risk Strategist, Ingenieux Wealth Management, Sydney, Australia predicts that capitulation of investors will probably happen. Here’s how she envisions it.

Now, we are likely to see a washout where just about everyone who has not sold will give up and sell. They will walk away from the markets and vow never to return again. This will be the complete revulsion stage. Only when this happens will the markets be in a position to begin to rebuild the technical damage. This will take time, and it now appears that the highs in the broad indices have been seen for many years to come.

People will have nightmares about the Great Crash of 2008 for years to come. They will lose trust in the entire financial system and in many of their advisors who allowed their accounts to lose somewhere between 25% and 50%. The small retail trader will leave the markets in disgust and distrust.

Dorn’s description is quite graphic. And she is saying that it is likely to happen. Make no mistake, she is predicting a once-in-a-generation change in investor perception. We’ll see if this extreme reaction comes to pass.

But please remember that stock market lows can only be identified in retrospect. Moreover, for people who follow a buy and hold approach, all of this may be of only intellectual interest. On the other hand, knowing that this kind of panic behavior can happen may steel you not to join the herd in selling at what may just be the wrong time.

photo credit: Bitterroot

Is It Different This Time? Part 4

“We cannot assume that even if the economic news gets worse that prices will decline further. It’s quite possible that prices are already reflecting investor concerns of more trouble ahead and may rise despite more gloomy business reports in days and months to come.” – Weston J. Wellington.
 
Today’s New York Times has two editorials, both of them well worth reading; one was written by Nobel prize-winning economist Paul Krugman and the other by Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway, who is touted as one of history’s most successful investors. At first glance, their respective opinions seem to be diametrically opposed, but that is only true if you don’t understand how the stock market works.

In Let’s Get Fiscal, Krugman assesses the outlook for the economy saying that there is “grim news coming in about the real economy.” Summing up the economic situation, he states,

Just this week, we learned that retail sales have fallen off a cliff, and so has industrial production. Unemployment claims are at steep-recession levels, and the Philadelphia Fed’s manufacturing index is falling at the fastest pace in almost 20 years. All signs point to an economic slump that will be nasty, brutish — and long.

Krugman predicts that the unemployment rate, which is already above 6 percent, “will go above 7 percent, and quite possibly above 8 percent, making this the worst recession in a quarter-century.”

“And how long will it last? It could be very long indeed.”

Upon reading that, it would be understandable if you decide to sell all of your stocks and put the money from the proceeds “under the mattress,” so to speak. If you’re at all in agreement with Krugman’s analysis, you might want to buy “safe” CDs or, if you are totally freaked out, short-term U.S. Treasury securities, that are paying very close to zero interest.

That understandable inclination of reacting to bad current news, and worse predictions of the future, though perfectly natural, would likely also be entirely wrong. The reason is that the stock market looks forward. What is already known is “priced in the market.” Stock prices have already fallen in anticipation of a worsening economy. If and when the economy declines further, that will only confirm what we think we know now, so stock prices may not decline any more from where they currently stand.

In other words, as an investor, you cannot read the news or even someone’s prediction on where the economy is going and “profitably” act on it. In the stock market, “what everyone knows is not worth knowing.”

Please note, that nowhere does Krugman give any advice on what to do as an investor. That’s not his area of expertise. I am only projecting what a knowledgeable layman might conclude from reading Krugman’s observations.

That brings me to Warren Buffett’s opinion piece. It is an understatement to say that Buffett is a very, very, successful long-term investor. He’s been called, among other things, the Oracle of Omaha and the world’s greatest stock market investor, and an empire builder. His favorite holding period is “forever.” He certainly does not try to time the market, as he believes no one can do that successfully. (There is a lot of academic evidence that people who do try to time the market end up with terrible results.)

In Buffett’s Buy American. I Am, he agrees with Krugman’s basic thesis on the economy.

The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

But here is the seeming paradox. What is Buffett doing?

I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.

Since no one can forecast the short term direction of the stock market, Buffet continues:

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

This is typical Buffett — folksy, but right on. He then writes about the Great Depression and World War II, and notes that buying when things look bleakest was the right strategy. He concludes that “bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.”

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later.

This is my fourth post in the series called Is It Different This Time?  Feel free to read the others, especially if you are ready to hit the panic button and sell your stocks and/or stock mutual funds.

photo credit: notsogoodphotography

Is It Different This Time? Part 3

“We are not going to have a depression, and we have survived financial crises before. A century of investing experience, as well as insights from the field of behavioral finance, suggest that investors who bail out of equities during times like these are almost always making the wrong decision.” – Burton G. Malkiel.

Alex Berenson’s October 11th article in The New York Times Those With a Sense of History May Find It’s Time to Invest is well worth reading, especially if you are discouraged enough to be considering selling your equity mutual funds and putting the money in CDs.

The four most dangerous words for investors are: This time is different.

In 1999, technology companies with no earnings or sales were valued at billions of dollars. But this time was different, investors told themselves. The Internet could not be missed at any price.

They were wrong. In 2000 and 2001 technology stocks plunged, erasing trillions of dollars in wealth.

Now investors have again convinced themselves that this time is different, that the credit crisis will push economies worldwide into the deepest recession since the Depression. Fear runs even deeper today than greed did a decade ago.

But in their panic, investors are ignoring 60 years of history. Since the Depression, governments have become far more aggressive about intervening when credit markets seize up or economies struggle. And those interventions have generally succeeded. The recessions since World War II, while hardly easy, have been far less painful than the Depression.

Berenson goes on to quote various investors and economists who believe that the pessimism is overdone and that this is a good time to buy rather than sell stocks.

If there is good and wise policy, and government moves effectively, this need not play itself out in ways like the Great Depression, which is the image that is playing itself out in people’s mind. . Government action typically does not work immediately, and banking crises around the world often require multiple interventions. – Stephen Haber, an economic historian and senior fellow at the Hoover Institution.

“I think in years to come — I wouldn’t say months to come — we will perceive this as being a great value-buying opportunity. Two and three years from now, it will seem very smart.” - David P. Stowell, a finance professor at Northwestern and a former managing director at JPMorgan Chase.

“This is the opportunity of a lifetime. The most important securities are being given away.” – Martin J. Whitman, a professional investor for more than 50 years.

photo credit: Sheffield Tiger

Recession or Depression? Part 3

“In their 1963 book A Monetary History of the United States, 1867-1960, Milton Friedman and Anna Schwartz laid out their case for a different explanation of the Great Depression. … The failure of the Federal Reserve to deal with the Depression was not a sign that monetary policy was impotent, but that the Federal Reserve exercised the wrong policies. They did not claim the Fed caused the depression, only that it failed to use policies that might have stopped a recession from turning into a depression.” – Wikipedia.

Definitions: Bear Market or Crash?  from the October 10th Forbes magazine provides useful background information.

Stocks are falling, unemployment is rising and even banks seem to be hiding their money under mattresses. It’s tough to measure how bad things are and impossible to say whether they’ll get worse. With commentators throwing around words usually reserved for the worst of economic times – crash, recession, depression – the one question we can answer is what those words mean.

The economy expands and shrinks in cycles, with times of growth followed by times of contraction.

In an expansion, manufacturers build new factories, retailers open more stores and, most of the time, companies hire additional workers. The 1990s saw a decade of growth, the longest peacetime economic expansion in U.S. history.

In a recession, the economy shrinks for months. Factories produce less, cutting shifts, or laying off workers altogether. Incomes fall. Sales drop. The last recession lasted nine months ending in November 2001.

A depression is a more severe and prolonged version of a recession. In a depression, prices often fall as unemployment rises. Shoppers drastically cut their spending. In the Great Depression, which began in 1927 and lasted for more than a decade, unemployment peaked at nearly 25 percent, and many of those who did work were only able to find part-time jobs. By contrast, the current unemployment rate is 6.1 percent.

Recent talk about depressions has been sparked by worsening economic data and the frightening drop in stock prices, which has been almost as steep as the 1929 crash that began the Great Depression. Most professional investors call a 20 percent decline within a few days a crash.

A 20 percent decline over a longer time is called a bear market. A bear market is a prolonged decline in prices for stocks, bonds, commodities, or all three. While there’s debate about whether the decline of the seven trading days ending Thursday was a crash, there’s no argument that we are in a bear market. The Dow Jones industrial average is nearly 42 percent lower than it was at its highest point last October; marking the largest decline since 1973-1974.

The opposite of a bear market is a bull market, which brings a prolonged increase in the price of stocks, bonds or commodities. Market historians may point to Oct. 9, 2007 as the crest of the most recent bull market – notching a 48 percent rise over five years – and the beginning of a bear market of undetermined length.

photo credit: Lee Jordan

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