Some Capitulation, but Probably Not the Bottom

Tuesday's session included something for both sides of the debate, but left unresolved the lingering question over whether last week marked a so-called capitulation low, a.k.a. the bottom.

Hindsight is going to be necessary to declare when an actual bottom has occurred. But I wanted to revisit the issues of capitulation and bottoms, which remain foremost in the minds of many investors.

Most market watchers believe some form of capitulation is necessary before a bear market can end. But what's vexing to many readers is that "capitulation" has varied definitions. The most obvious form occurred in 1987, when investors bailed out of stocks in a quick and bloody "washout" encompassing a handful of sessions and culminating on "Black Monday," Oct. 19, 1987. Conversely, capitulation occurred in a long and begrudging fashion in the 1973-74 bear market.

It can be argued the present cycle has seen a combination of the two -- a painful 18-month bear market punctuated by last week's historic declines.

But a common theme in previous cycles was a sense that investors wanted to sell stocks at whatever price was available because the pain of more losses was intolerable. The prevailing sentiment thereafter was, "I never want to own stocks again." Robert Farrell, senior investment advisor at Merrill Lynch, made that point in an interview on CNBC Tuesday.

The bearish take is that investors haven't gotten anywhere near that point in the current cycle. Be honest: Are you more concerned about missing the next rally or the next big decline? Skeptics further note that there are too many people looking for and predicting a bottom for one to emerge.

"Too many stand ready to buy," Alan Newman, editor of H.D. Brous' Crosscurrents, commented on Monday. "For us to turn bullish we need to see strategists ... tone down their bullish stance; mutual funds pile up cash reserves; [and] the public sour on the long-term mantra and go to cash, rather than invest."

Newman, whose downside targets that once seemed so Draconian came to fruition last week, acknowledged "one of the greatest short-covering rallies" in history could emerge short term. But he doesn't believe a new bull leg can develop until there is a sea change in the mindset of investors, both professional and retail. "In the meantime, this is a bear market, and lower prices should be expected at some point," he wrote.

John Bollinger, president of BollingerBands.com in Manhattan Beach, Calif., agrees lower prices are likely, suggesting some retest of last week's lows is "almost certain."

But the "preconditions for a bottom are in place," he declared. Among myriad other technical indicators at oversold levels, less than 2% of major industry groups were trading above their 10-, 50- and 200-day moving averages last week -- an all-time low, Bollinger said.

Additionally, the technician believes institutional investors capitulated last week, as evident by the "huge boost" in block trading and "massive put buying" on both an absolute and relative (to calls) basis.

"You can say there was no capitulation, but tremendous damage [has been] done" to investor psychology, he continued. "Capitulation means different things at different times" but the "local variables" of last week's decline suggest "we have reached a climactic point in the decline."

Still, Bollinger's outlook is for a "giant sideways trading range for the balance of the decade," not a new, roaring bull market. His strategy going forward is to practice "swing trading" in what he called the "old-fashioned sense of the word": Focusing on group sector rotation prescribed by "major moves" in daily and weekly charts.

Elsewhere, Stanley Nabi, managing director at Credit Suisse Asset Management, is bullish now after being bearish "for a long period," during which he "snickered" at those who spoke of "new eras." Having spoken to Nabi over the years, I can attest that he did.

Some capitulation has occurred, Nabi said, noting, "many of the people who were wildly bullish at the peak are [now] in deep depression." Steadfast bears will disagree, but he also argued the downturn that's occurred is "appropriate and consistent" with the size of the late-1990's bubble. The average stock in the S&P 500 is down over 50% from its all-time high, Nabi said, suggesting the correction has been even deeper than declines in the S&P and Dow indicate. (The Nasdaq is another story.)

"The bottom may not come for several more weeks, but the value is very evident," said the veteran money manager, who oversees more than $1 billion.

Nabi spies value based on the following: The last full year for economic recovery after a "significant recession" was 1983. Assuming a substantial recession is now occurring, he predicts 2003 is going to be the initial full year of recovery. Assuming 20 years of 7.5% compounded annual earnings growth -- the postwar average -- added onto 1983's S&P earnings of $14.03, Nabi derived estimated 2003 earnings of $59.75. The current First Call/Thomson Financial consensus is $62.50.

Based on $59.75, the S&P is trading with a price-to-earnings ratio of about 17, around the postwar average. In addition, the market is 15% to 20% undervalued based on the dividend discount model, and "we're in a period of low inflation," giving the Federal Reserve flexibility, he argued.

Certainly one can quibble with Nabi's assumptions about earnings growth, "fair" value, and inflation expectations. But the intent here is show how one real-time money manager is making real-time decisions, not to debate the merits of them.

Unable to reveal what he is currently buying, Nabi said Credit Suisse Asset Management is either already long or considering buying the following blue-chips, where he said value is most evident: American Express (AXP), General Electric (GE), Bank of New York (BK), Merck (MRK), Mellon Financial (MEL), Pfizer (PFE) and Citigroup (C).

So Newman, Bollinger and Nabi disagree on what level (if any) of capitulation has occurred, or how aggressive investors should be going forward. But notably, none believe the market is about to embark on a V-shaped recovery.

Almost no one is seriously making that argument -- one exception being Don Hays of Hays Advisory Group, who hosted a conference call Tuesday entitled: "100% Stocks, 0% Cash -- A Very Rare Occurrence!"

Look for more on that call, and Hays' stubborn bullishness, in a report later.

Home Stretch

A few weeks ago I mentioned that my wife and I are expecting our first child. At the time, it appeared early labor was possible. Now, she is a few days past her "official" due date.

I mention this because many readers have sent heartfelt emails, for which I'm truly grateful. Additionally, I wanted to remind you that I will be taking some time off after the baby arrives, which literally could be any moment now.

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