June 15, 2002

I recently became aware of a rather interesting -- but flawed -- research piece by Alan Newman of Crosscurrents, titled "Capitulation Remains Elusive." (My thanks to Aaron Task of TheStreet.com for bringing this to my attention).

The Crosscurrents article, and the mega Bear case contained therein, are interesting enough that it is worth analyzing the arguments put forth. You should go to that link right now, and read what they have to say. After you are scared witless, come back and we'll take a shot at deconstructing the Bearish case they make.

If you are unfamiliar with Crosscurrents, they are usually both thoughtful and thought provoking. Their claim to fame was an appropriately Bearish posture long before it became "fashionable." Indeed, their subscribers received ample warning before the April 2000 crash; "Pictures of a Stock Market Mania," an early research piece of theirs, should be required reading on Wall Street. (I much prefer using a logarithmic chart anytime I'm reading a multi-decade long chart, but why quibble over that now?)

Because their site went live in '99, however, I do not have their longer term track record.

Unfortunately, the "Capitulation Remains Elusive" article, is not up to their usual standard. Crosscurrents' best work focuses on in depth technical price action and econometrics relative to historical norms. The Capitulation piece, however, appears to be, at best, a bit disingenuous.

Since it has become nouveau chic to write about the Bear case -- its certainly having an impact on investor sentiment --I thought it might be "educational" to look at some of the Bear arguments put forth, and deconstruct them:

1) "Bulls claim that the move to the September 2001 lows represented a true "panic" low and that action since has been a bull market. We would hope to be amongst the first to buy a true "capitulation" bottom, but in our views, the September '01 lows were something quite different." 

How can one seriously discuss capitulation, yet ignore the cascading sell off of the week of September 17 through 21st? It warranted exactly 6 words in the entire article. That strikes me as omitting a rather crucial fact. Lets look at the specifics of that week:

a) DOW: After taking 18 months to fall from 11,350 to 9500 -- a drop of 16.4% -- the Dow plummeted another ~16% to 8062 in 5 days; The Industrials essentially doubled 18 months worth of losses in a week. This certainly has the appearance of a denouement -- a panic based blowoff.

b) S&P: The SPX fell 28% from its peak of 1530 to 1100; The September drop to 944 was a one week loss of 14%. In other words, a drop half again as large as the prior 18 months, on a percentage basis.

c) COMP: Nasdaq had fallen 67% from 5103 to 1689; its 5 day September losses tacked on an additional 18% drop;

Omitting 1 week drops of 17, 14 and 18 percent on the indexes -- and then saying there was no capitulation -- is rather specious.

Jim Cramer notes that "9/17 - 9/21 was the "second- to-worst-week in the history of the stock market" (Lights Out Until GE Bottoms). Why wouldn't an almost unprecedented degree of rampant stock dumping qualify as capitulation? That's a tough argument to make, but Newman (Newman!) claims that we need to see more people with negative sentiment. Here is his definition:

2) " 'Capitulation' is not defined by price decline alone.  "Capitulation" is primarily defined by sentiment."

I am of the firm opinion that Brous' definition of Capitulation is simply wrong. Capitulation is an act; It requires much more than mere sentiment -- it involves very negative sentiment leading to very strong action:

The phrase "Capitulation" is derived from military usage -- it refers to the act of surrender. An enemy capitulates in the face of overwhelming force and near certain destruction. "In stocks, it is associated with "giving up" any previous gains in the stock price. True capitulation involves extremely high volume and sharp declines (oversold stocks), it usually indicates panic selling." (Source: Investopedia)

3) "Sector rotation, wholesale dumping of disappointing issues, accumulation of new "sizzle" stories and the like continue to fuel aspirations, if not prices.  In fact, rotation from large overcapitalized issues where prices could not possibly be sustained, into smaller capitalized issues, promoted a bull market in smaller stocks."

The critique of rotation (away from big caps into small and mid caps) as signs of a Bull mania is simply wrong. We saw a "stealth Bear market" from April '98 to the April 2000 crash, as money rotated away from the rest of the stock universe and into the biggest caps S&P stocks. This was due to "closet indexers" pursuing their benchmarks, and it was a misleading in the extreme: Because the S&P is market cap weighted, the indexes rallied while most other (non mega cap) holdings were going down over this period.

In fact, in "Pictures of a Stock Market Mania," Crosscurrents correctly notes the narrowing of the market to a handful of the largest capitalized stocks as a warning sign; The Bullish indexes led by an increasingly smaller numbers of monster stocks -- were masking the internal problems, hidden beneath the market's surface.

But you cannot have it both ways: If the narrowing of the market into a tiny group of overvalued mega cap stocks is Bearish, than how can a broadening out of the market into much larger collection of smaller cap, lower valuation stocks still be a Bearish development? Its EXACTLY the opposite of what was complained about in the 1999-2000 time period.

Its ironic, because the market have seen a reverse of the prior "stealth Bear." Since the Fed began aggressively cutting rates last year, a "stealth Bull market" has been quietly forming. For over a year, while the big cap stocks -- telecom & tech in particular -- have been getting utterly mangled, many smaller and mid cap stocks have not only held up, but indeed, have actually moved higher. Just yesterday, Don Hays (of Hays Advisory) pointed out "that ¾’s of the 500 stocks in the S&P 500 have increased in price by an average of 30% since the September 21, 2001 bottom. [To the Bears] it doesn’t matter that the S&P 600 is up over 25%, or the Value-Line Arithmetic index -- which equally weights the most popularly traded 1600 stocks in the U.S. -- is up over 20%."

According to Newman, this broadening out of the market away from huge cap stocks with undefendable valuations is a sign that there is still too much Bullish sentiment. I simply must disagree. It shows that common sense valuation sensitivity has been coming back into the market, and an unsustainable focus on the "Nifty Fifty" type stocks has run its course (granted, it was a long time coming).

4) Something omitted entirely by Crosscurrents is that the post capitulation rally got out of hand: Too much fast cash/momentum money -- previously in short positions -- came roaring back to cover and go long. I suspect Newman & I would agree with a critique showing that there is still too much speculation in the overall market. However, it was mostly institutional and professional trading -- not Main Street or "Mom and Pop" investors. However, I doubt that this money could be wrung out of the system, as it is simply too nimble and too focused on capital preservation to ever be totally blown out. It is quite often -- both long and short -- the "smart money."

Note I discuss this (exhaustively) in: "September 11th and the Markets: 6 Months Later."

5) "While we are on the subject on stock market timing, we should note that professionals advice to "stay the course" has placed investors in their worst position for any three year period since the Roaring Twenties bust collapsed prices by 90%.  The shock (wealth loss) registered after the prior mania surged as high as 58.7% of GDP and was probably one of the primary drivers of the depression."

No disagreement here; Investors do hang in there too long -- but this is certainly nothing new. It's Human Nature to hope for the best; We are undoubtedly an optimistic breed. But that doesn't mean its a good investing strategy to ride stocks down 70, 80, 90%. The long term myth is still alive and well at the big wire houses. In my daily review of Portfolios from Merrill, Morgan Stanley, Smith Barney, I see an appalling lack of risk management, capital preservation, and loss limitation. So Newman's point here is very well taken.

Further, as long as Buffett is considered a God, this theory will persist. (Disclosure: I am long Berkshire Hathaway B shares; I can't argue with his level of success -- even if I don't believe his "Buy and hold forever" routine. This is called flexibility).

6) "Although the bear views of luminaries such as Sir John Templeton have been on display a couple of times in recent months, we still see a paucity of those correctly committed to the bear case for equities, particularly those who have been so eloquent and so correct for several years, like David Tice of the Prudent Bear fund and like Charles Minter of Comstock Funds."

Simply not true: It has become de rigueur to trot out the Bears now on CNBC and CNN fn. Fox's " "Bulls and Bears" show has a regular line up of Bearish voices.

Further, 'though commentators may freely mention David Tice as an "eloquent Bear," they would be remiss if they failed to point out that he has been Bearish since around the time that Fire was invented.

Tice is a PermaBear, the flip side of the perma-Bull coin. Guys like Joey Baggadonuts were appropriately Bullish throughout the entire upwards cycle. But they overstayed their welcome, as they were also Bullish as we plummeted through 5000, 4000, 3000, 2000 -- until they were pretty much banned from TV.

Now that we are deep into the Bear cycle, guys like Tice suddenly get some facetime on the Tube. But that doesn't make them prescient prognosticators. It merely points out that each side of the Bull/Bear argument will eventually be right. (See "Bull or Bear?" for more on this debate.) Note the telling phrase "committed to the bear case;" That's the gist of the problem with Perma anything. The market is cyclical, and you will be alternatively right and wrong over time. Problem is, your capital disappears as you wait for the market to realize the "correctness" of your position.

As an antique watch collector, I know that even a broken timepiece is right twice a day -- but I certainly can't rely on it to tell me the correct time . . .

Here's a fun thought experiment: pick one of the following -- an umbrella or a pair of sunglasses. You get to carry the one you chose every day for year, to the exclusion of the one you did not select. Assume a moderate, seasonal climate. Which is the right choice?

Thats the problem with marrying a position -- you'll be half right and half wrong. The better strategists have flipped between bullish and bearish postures half a dozen times or more over the past 5 years. Not perfect, but at least flexible enough to preserve capital.

7) "It is duly noted that CNBC has presented more of the bear case in recent months, but why did it take so long?!  Why is the bear case still not given equal time with the bull case that is reiterated time and time again to the disadvantage of their viewers, CNBC's own customers?!"

CNBC certainly captures the Zeitgeist of the moment, but it is a lousy basis for making investment decisions. Those who "invest" off of TV journos unfortunately get what they deserve. (Check out Martha Smiglis' great San Francisco Examiner piece: "Rah-rah CNBC had the suckers going for a ride").

Further, it helps to understand the business CNBC is in; Their customers are not the viewers; Rather, they are the advertisers who pay CNBC for access to those viewers.

Of course, if CNBC continues to deliver mediocre entertainment and information, those viewers -- especially the most coveted, affluent ones -- will tune in elsewhere. But understand that CNBC is "for entertainment purposes only."

8) "For the last few years, we have commented upon seasonal effects, calling the May to October period the Dead Zone.  Throughout the period covering 1950 to the present day, virtually all of the stock markets gains have come in the period November through April, and virtually none from May to October.  In fact, $10,000 invested for just the months of November to April would have grown to $465,472 since 1950.  The same $10,000 invested solely from May through October would have gained less than $115!"

Some may see this as my most petty critique, but I cannot help myself: As someone who writes, I find it disturbing to see the "Sell in May/Go Away" argument made without giving at least giving a modicum of credit to Yale Hirsch of the Stock Traders Almanac.

I do not know who was the very first person to identify this trend, but its been Hirsch's baby for so long now, that I could not imagine citing this work without crediting Hirsch.

Conclusion I've seen Crosscurrent's work for a few years now. The "Capitulation Remains Elusive" work is not up to their usual intellectual rigor. It was misleading, riddled with selective omissions of key facts. It is inconsistent with their prior analyses making the Bearish case. There is too much hyperbole and exaggeration, compared to their usual disciplined approach. (I've left myself open to charges that "Me thinks he doth protesteth too much.")

In doing market analysis, it is helpful to consider a variety of work from thoughtful commentators with an open, but critical mind. I hope you found this analysis to be consistent with that philosophy.

-Barry Ritholtz

June 15, 2002

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