Gloom marks the market, a period of capitulation

Some analysts say the market appears to be going through capitulation, a period of heavy selling marked by pervasive gloom, when investors ignore good news and throw out the good with the bad.

Many, but not all, bear markets end in a capitulation. When everyone who wants to sell has gotten out, a modest influx of buyers can lead to big gains.

The past week's sell-off "absolutely" felt like capitulation, says Ed Yardeni, president of Yardeni Research. "It's total and complete revulsion. People are chucking out stocks, saying get me out of here. What we're learning is that capitulation doesn't have to happen in one day."

The problem with capitulations is that they are hard to identify, except in retrospect. A lot of selling that feels like a capitulation really isn't, while a real capitulation is not always obvious. Sometimes, though, people get it right.

On Oct. 10, 2002, the Dallas Morning News ran a story titled "Darkest near the bottom." It started like this:

"Stocks received yet another cruel mugging Wednesday, pushing the Dow Jones industrial average to a five-year low. So is a selling climax at hand? Once again, there's a growing consensus among Wall Street pros that a day of final capitulation must be near. It had better come soon, though, or there won't be an investor left standing who cares anymore."

Although the day described did indeed mark the end of the bear market, it wasn't obvious until long after. At year-end, news reports were still questioning whether investors had thrown in the towel. In early 2003, the stock market tumbled again, although it never got as low as it did the previous October. It wasn't until March 2003 that the market started its long upward climb.

Another problem with capitulations is that no two are alike.

"This is slow-torture capitulation," says Stewart Pillette of Pillette Investment Management. "It's doing it in a way I've never seen before in my 45 years. Usually you get (days when the market is down 600 or 800) and then you get relief."

Pillette says his analysis of the market suggests it could fall 5 to 15 percent more. "Fear is not rampant yet," he says. "Almost everybody I talk to in the institutional world is expecting a big bounce. Because that's so pluralistic, I doubt that we are going to get it. My guess is we probably get it after the elections."

Nevertheless, Pillette says he has been buying stocks.

"Liquidity is abundant. There is more money sloshing around now than in my memory. It's not working because of a lack of confidence. The confidence is really a function of what bank is going to fail next," he says.

"I'm starting to nibble because I don't know where the bottom is," Pillette explains. "I bought a little Cisco today at $17.50. My thought is, if it goes to $13, I'll buy it on the way down. I'm doing the same with Intel, General Electric. I'm trying to find high-quality stocks that have been thrown away."

Meir Statman, a finance professor at Santa Clara University who studies investor behavior, says he's not going to "stick my neck out" and call this a capitulation.

"The decline in the price (of stocks) justifies the fundamentals," he says. "It's not all just panic."

Yet the odds favor a turnaround, eventually.

"What I know from my studies is that individual investors tend to extrapolate recent trends," Statman says. If stocks are going down, they think stocks will continue to go down.

"I also know that generally, those expectations turn out to be wrong. When people are most pessimistic, the likelihood is greater that the market will go up." But he adds, the odds are not necessarily high. "It's like saying there's a 53 percent chance the market will go up and a 47 percent chance it will go down."

But sometimes ...

Sometimes, he warns, "people are pessimistic and the market still goes down."

The opposite is also true. Former Fed Chairman Alan Greenspan warned of "irrational exuberance" in the market in 1996. The market continued climbing until 2000.

Many investors have been burned overestimating how soon investors will become rational.

As John Maynard Keynes supposedly said, "Markets can stay irrational longer than you can stay liquid," Statman says.

The numbers bear witness to the saying that stocks fall during the fall -- and October has been the cruelest month.

Oct. 19, 1987: Black Monday. Starting in Hong Kong and spreading west to Europe and the United States, markets around the world crashed. The Dow lost 508 points to 1,739, or 22.6 percent of its value.

Oct. 24, 1929: Black Thursday. Recognized as the beginning of the Great Crash of '29. But it wasn't until the following week, Black Monday and Black Tuesday, when the Dow lost nearly 25 percent of its value and widespread panic hit Wall Street.

Oct. 9, 2008: A huge sell-off just before the closing bell sends the Dow down 679 points, or 7.3 percent, the ninth-largest percentage drop since the Great Crash of '29.

(Distributed by Scripps Howard News Service, www.scrippsnews.com.)