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Weekly Market Perspective
July 22, 2002
The Capitulation Phase
Capitulation is a concept that marks the final phase in a market's direction. It's an exhaustion point where buyers have all bought or sellers have all sold. Normally, but not always, market capitulations have a climatic "big bang" characterized by spikes in trading volumes and price volatility. Bear market capitulations are scary and the wounds to portfolios and investor emotions are painfully visible. Most of the bear market capitulations of the past 20 years have been relatively short, lasting as little as three months. The current bear market, however, appears to be headed to the historic proportions of the unprecedented bull market, which preceded it.
The current bear market that began in March 2000 is now running 28 months, making it the longest period between a market peak and new low since the Depression. The S&P 500 has declined by 45% and the NASDAQ Composite by 74%. But alas, bear markets do end and the great lesson of the past is that they do create opportunity for investors. Whether we are now at such an opportunity will only be determined by the passage of time that allows for a post-capitulation market to consolidate and then gain the footing for the upward move that has been the American bull market reality for the last 200 years.
The telltale signs of bear market capitulation are extremes from normalized conditions in selling pressure, investor sentiment, and valuation. As the extremes become evident, the probability of a market low increases and the risk/reward opportunity for owning stocks improves. The acceleration in selling in the last two weeks has pushed the market to such extremes. However, conditions can become more extreme before a firm bottom or final capitulation phase is in place. The period between now and the August 14 deadline for CEO compliance with the SEC's requirement that they verify past financial statements will keep investors on edge. Extraordinary opportunities are being created, and we urge risk-tolerant investors to prudently and patiently take advantage of market volatility to buy distressed, quality stocks. We review the capitulation evidence below.
Selling Pressure
Selling pressure can be measured in a variety of ways. In terms of trading volume, last week's NYSE has its second-highest weekly total in history (second to post-September 11 week) and last Friday broke the single day record. The weekly total of stocks reaching a new 52-week low on the NYSE was the highest (579) since the post-September 11 period.
The sustained selling pressure becomes more extreme when comparing stocks to their average price over the past 10 weeks. Within the S&P 500, 99% of the stocks are below their 10-week moving average and there is no real parallel to this number. It is higher than the post-September 11, the stock market crash of 1987, and bear market bottom of 1974. The 90% threshold in the S&P 500 has proven to be coincident with every important market low for the last thirty years.
Investor Sentiment
Surveys of investor attitudes that cover the range from the professional to individual investors are showing a dominance of bearishness that has been a reliable contrary indicator of every major bear market bottom.
According to Trim Tabs, the weekly redemptions of equity mutual funds are on track for the highest monthly outflow of assets ever. Again, a prominent and contrary indicator.
The short interest on the NYSE has recently been reported as the highest in history, again a fairly reliable contrary indicator. The S&P 500 proxy traded as the SPDR Trust (SPY) is showing that 14% of its outstanding shares as of July 2 were sold short, which is more than double the amount from a year ago. Interesting enough, the NASDAQ 100 proxy (QQQ), has been declining from a peak last December.
Foreign investors were the only owner category to increase their share of U.S. equities in an absolute sense since the market peak in March 2000. While it is difficult to quantify foreign selling, the combination of market depreciation and a 10% decline in the trade-weighted dollar has no doubt soured sentiment that had grown foreign ownership share of the U.S. market to 11.5% in March 2002 from 7.9% in March 2000 and 3.5% in 1995.
* Margin debt typically contracts in a bear market and the contraction and the low level relative to equity market value is a sign that speculative forces have been wrung out. Margin debt peaked in March 2000 and has declined by almost 50%, which is similar to the contraction of the 1972(74 bear market and much greater than the stock market crash of 1987.
Valuation
The issue of valuation is the most problematic to the case for capitulation. P/E ratios and other standard valuation measures are, in an absolute sense, far from their extreme low. However, context is important. The rate of inflation and interest rates are conditional factors that influence valuation. Pragmatically, the choice in financial assets comes down to the attractiveness of stocks versus bonds or cash. With interest rates and inflation at generational lows, equity valuation has contracted to attractive levels relative to financial asset alternatives, in our opinion.
In 1974, the bear market contracted the S&P 500 P/E ratio by almost half, from 19.0x to 10.0x. But interest rates and inflation accelerated from the prior bull market peak. Creating an index of S&P 500 P/E ratios on trailing-12-month EPS plus 10-year Treasury yield plus annualized inflation produced a bull market peak index value of 28.6 in 1972 (19.0 P/E + 6.0% T-Bond yield + 3.6% CPI.) Using the lower P/E at the bear market bottom in 1974 but then higher interest rates and inflation produced an index value of 24.0 (10.0 P/E + 7.7% T-yield+ 6.3% CPI). Applying the same methodology to the bull market peak in March 2000 produces an index value of 37.7 (28.0x P/E + 6.7% T-yield + 3.0% CPI). The current index value as of July 19 is 28.3 (21.8x P/E + 4.5% T-yield + 2.0% CPI). Unlike 1974, the current index reflects a much sharper drop in operating EPS. Using estimated operating EPS for 2002, the index value drops to 23.5. The point is that S&P 500 valuation has meaningfully corrected, and in the context of interest rates and inflation, below the level at the bear market bottom of 1974.
P/E ratio is only one dimension of the equity valuation puzzle. Again, with reference to an investor's choice of financial alternatives between stocks, bonds, and cash, valuation is favoring stocks with the following comparisons.
The Fed Model, which compares 10-year Treasury yields to consensus forecast of year forward S&P 500 EPS, is indicating that stocks are extremely undervalued relative to bonds. Similar periods of undervaluation for stocks have produced well above average gains for the S&P 500 in the ensuing 12 months.
For the first time since a very brief period in 1992, the dividend yield on the S&P 500 is exceeding yields on six-month Treasury Bills. The normal relationship is for T-bills to yield twice the dividend yield. Going back to 1968, stocks have a strong record of positive performance whenever the T-Bill/Dividend yield ratio is below 1.3:1.
Money market funds assets currently represent over 26% of entire equity market (Wilshire 5000) and now exceed the ratio at the start of the bull market in 1982.
Capitulation and the Wall of Worry
Capitulation doesn't mean that all the problems that caused a market decline go away. Rather, it is the point at which the critical mass of selling related to the problems has been discounted. If the 1974 bear market experience is instructive, markets can recover sharply in the face of a crisis in political leadership, energy shortage, corporate scandals, credit crunch, and escalation of inflation that was unknown to a generation of investors. There are significant challenges ahead for financial markets, but with a starting point of capitulation and pessimism, the probability of achieving a higher return in equities than bonds or cash has increased, in our opinion.
Richard E. Cripps, CFA
Chief Market Strategist
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