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Wall Street Journal: Capitulating, whatever that is, is what investors haven't done

Stocks won't end their free fall and start to rally again, many market pros have been saying of late, until there is capitulation by investors.

But if and when capitulation will come is a matter of great debate, in part because what would amount to capitulation is itself a matter of debate. There is one area of agreement, though: It hasn't happened yet, despite how painful Wednesday and Monday felt.

In general, capitulation means that many investors have lost faith in stocks and have surrendered — so that everybody who is getting out of the market already has sold out, which relieves downward pressure.

The problem is capitulation means different things to different people, and doesn't necessarily signal a market bottom, though it does mean things are likely to get better in the near future.

Market analysts say a true capitulation has all the subtlety of an XFL cheerleader, but such in-your-face capitulations are pretty rare. "In my view, the only total bear capitulations we've had since 1982 are 1987 and 1998. We have had more sector capitulations, but I can't think of another broad-market one," says Jim Paulsen, chief investment officer at Wells Capital Management.

What is true, though, is that massive down days, whether technically considered capitulations or not, usually lead to sustained rallies. Historically, the market has almost always been higher a year after its biggest down days.

There are two ways to look at capitulation, psychologically and statistically. The psychological is the simplest to understand and the hardest to prove. That occurs when investors are disgusted with the stock market and will do anything to wash their hands of their dreadful holdings. "Is sentiment totally destroyed?" asks Tobias Levkovich, a strategist at Salomon Smith Barney. That, he says, "is one of the things you look for."

So far, by most accounts, that hasn't happened. The big discount securities brokerage firms say the individual investors they cater to aren't dumping their stocks, and while individuals have cut back their purchases of stock mutual funds, they haven't been selling en masse and instead are generally parking their savings in cash.

"There's still a desire to own technology out there," Levkovich says. "Capitulation would be when it was gone, when people say, 'I never want to own a tech stock again.' That's total capitulation. We're not there yet."

Market psychology, with apologies to psychologists, is a messy game, though. No one knows how investors really feel. In fact, most gauges of investor sentiment are considered contrarian indicators, meaning that when investors all head in one direction, they are most likely going the wrong way.

Professional traders have no patience for this. They gauge sentiment by the numbers, and the numbers they are seeing tell them there is no capitulation at hand. The most obvious signs of capitulation are the markets' overall decline and total volume. While Wednesday's 3 percent, 317-point decline in the Dow Jones Industrial Average certainly got people's attention, volume was nowhere near a record. Monday's 436-point drop in the Dow industrials also didn't make the list of biggest down or highest-volume days.

Traders look inside the market for clues about capitulation. One key factor is whether a market decline is widespread — or concentrated in just a few stocks.

By that measure, this week has been interesting. Even as the Nasdaq Composite Index has crumbled over the past year, the volume of stocks declining relative to the volume of stocks going up hasn't been high by historical standards. That means the carnage has been concentrated in tech and telecom stocks rather than in the broad market.

This week, though, the declining-vs.-advancing volume ratio has risen to levels not seen in a year — meaning more stocks are feeling the pain — though not to the levels that make things really ugly. Wednesday the numbers hit 8-to-1 on the New York Stock Exchange, following Monday's 12.1- to-1. By contrast, the ratio on Oct. 19, 1987, the day the Dow industrials fell 22.6 percent, was 533.4-to-1, and on Oct. 27, 1997, during the big selloff at the start of the Asian financial crisis, it was 168.1-to-1, according to Ned Davis Research.

Then there is the fear index. Among the numbers nearly every professional trader keeps on his or her screen is the Chicago Board Options Exchange's market volatility index, known as the VIX. The VIX measures the price investors are willing to pay for put options, which protect you in a market downfall, vs. call options, which let you benefit from a market rally. When the market drops, the VIX rises as nervous investors pay up for protection.

On Monday, the VIX shot up 9 percent to 35, a reading that indicated that investors were worried, and, after falling on Tuesday, it ended Wednesday at about the same level. But that only earns a shrug from traders who saw the VIX top 55 both in the summer of 1998, during the Russian debt default and the meltdown at hedge-fund Long-Term Capital Management — considered the only true capitulation in recent times other than the 1987 crash — and in the summer of 1997, during the Asian financial crisis.

Many traders have called the last few days a buyers' strike, meaning that there has been moderate selling, but that prices have declined so much because no one is buying. Indeed, traders at the New York Stock Exchange said things were quiet, almost boring, Wednesday. By contrast, during a real capitulation, there is massive selling and total panic at the exchange.

To some extent, the broad market already had its big selloff — early last year, when investors were dumping everything but tech stocks. Fund managers were getting fired and big-name investors were closing up shop.

"The real capitulation might have come in February of 2000," Wells's Paulsen says. "The vast majority of the stocks in the NYSE were in free fall in the first 60 days of that year."

The lack of real terror Wednesday has led some analysts to say there may not be a widespread market capitulation this time around. Even the technology sector, which has seen every industry within it get knocked down in the past year in what has been described as a rolling bear market, may not experience a final wipeout.

"It's been like a tornado going from trailer park to trailer park," Levkovich, the Salomon strategist, says of the tech correction. "There's not a whole lot left standing."

If there is no capitulation to signal to investors that they should get back into stocks for the rally, the alternative may be a long slow slog back into favor for the big-name tech stocks, the equivalent of a protracted purgatory for investors. "Capitulation in large-cap tech might not come from fear, but from boredom," says Paulsen.