Investing can be an emotional roller coaster and can make mice out of the strongest men. We have all experienced the pain of being right too early and sold out of a winner before its time. Avoid being one of the crowd by using a volume rule to avoid panic selling and find stocks where the pain may have run its course.
Being right too early
We have all been there. You have a rock-solid outlook on a stock and put it into your portfolio. It may do well for a while but then it starts to plummet. Your profit turns to loss but you never doubt the upside potential. You may even buy more shares to lower your average price per share.
But the shares keep falling and you start to worry. Everyone else in the market seems to be saying that the stock is dead money or worse. It may take a while but you finally decide to take a loss instead of riding the shares down any further. Maybe your analysis was flawed.
And that is when the stock starts to rebound. Even though you do not have a position anymore, you can't help but keep it on your screen watching as it eventually reaches your target price and beyond.
Capitulation, a fancy word for panic
While you always need to be ready to reevaluate the outlook on the stocks in your portfolio, giving in to this kind of panic selling is how rational investors make money off of the rest of the market. Rational investors with a long-term focus use volume as an indicator of selling and how it marks a very important idea in investing.
That idea is capitulation. When a stock starts to drop, many retail investors with a marginal outlook on the shares will sell out their positions. As the shares drop further, even the investors with stronger conviction and longer-term horizons will begin to sell. Sometimes this happens over weeks or months with average volume. If panic grips the shares, volume spikes as everyone tries to get out at once. This panic selling is called capitulation, when even the strongest voices for the company throw up their hands and give up.
The idea of capitulation is even more important because investors absolutely detest realizing losses. In a common behavioral trait called loss aversion, investors will hold on to losers despite facts that would lead them to sell. They just want to get even on the shares, no matter how long it takes.
Of course for every seller there is a buyer but many of these new buyers are short-term traders looking for a bounce on lower prices. The supply and demand for the shares has definitely changed.
The capitulation point in a stock is so important because it marks the point where panic has moved the market out of the shares and only the truly die-hard remain. With only those that plan on sticking around through thick and thin, there are fewer sellers of the shares and any new buying interest will support the stock.
There is no numeric definition for capitulation but investors can use past data on a stock to see where the short-term investors start getting worried. First, start by downloading the daily price history off of Yahoo Finance or another service. The most recent years are the most relevant because they represent the current sentiment in the stock.
Calculating the daily percentage change in price, you want to look at a distribution of the days with losses. I like to focus on those days with a loss greater than three percent. For those days, usually separated in two groups (3% - 5% and greater than 5%), find the average volume of shares traded. This average volume will usually be higher than that traded on up days but it does not necessarily mark a capitulation point.
I like to look for days with volume at least 1.5 times the average volume for that group of losses. For example, if volume in a stock on days of losses between 3% to 5% averages five million shares, I like to look for days with losses in that range and volume greater than 7.5 million shares. You can use more technical criteria like standard deviation but I have found that this 50% bump in volume usually signifies a good capitulation point.
Three stocks facing capitulation and one with further downside
Researching the point, I found three stocks that may have reached their capitulation point and one that may have farther to fall. The table below shows the average volume over the last two years on days with price losses.
Joy Global (NYSE:JOY) is down 20% this year on weakness in commodities prices and China demand. The company is perpetually in the news as a potential takeover target. At 8.0 times trailing earnings, the shares trade cheaper than 90% of peers in construction and mining equipment. Even with the slowdown in capital expenditures for mining companies, the company is expected to post record sales this year and is one of the most profitable in the industry. Management is able to convert 13.6% of sales to net income, more than twice the industry's 6.4% net margin. Whether the company is ever bought out or not, it is superbly managed and extremely cheap.
The shares may have reached a capitulation point on August 28th with a loss of 4.7% and volume of 8.4 million shares, almost three times the average downside volume. Shares have rebounded 8% since then but are still well off their fair value of $80 given trailing earnings of $6.72 and a five-year price multiple of 11.9 times.
Chico's FAS (NYSE:CHS) is down 7% so far this year on a terrible first quarter report where it missed expectations for top-line and earnings growth. The shares trade for just 15.8 times trailing earnings, a discount of 25% on an industry average of 21.2 times earnings. The shares have been stronger lately on a string of analyst upgrades, most recently by KeyBanc. The company runs three stores; White House/Black Market, Soma Intimates and Boston Proper in 1,357 locations across the United States. The poor quarterly results were largely a result of tough comparables last year and an unseasonably cold spring which caused the company to mark down merchandise. The brands are not the strongest in fashion but the shares pay a 1.4% dividend and earnings should improve later in the year.
The shares may have reached a capitulation point on May 29th with a loss of 7.1% and volume of 10.3 million shares, just under 1.5 times the average volume of drops of more than five percent. Shares are down another 5% since then but the selling pressure has definitely slowed.
ADT Corporation (NYSE:ADT) is down 10% since January on competition from other providers of security solutions. The shares trade for 22.6 times earnings, a 24% discount to the industry average of 30 times earnings. Vringo Incorporated (VRNG) recently filed a patent infringement lawsuit against ADT and Tyco Integrated Security for its patent to remotely monitor a surveillance area. The stock could be volatile until a resolution is reached but the long-term potential from demographics is positive. ADT has a limited trading history but shares trading for as high as 28 times trailing earnings last year.
The shares may have reached a capitulation point on July 31st with a loss of 4.8% and volume of 9.4 million shares, almost double the average downside volume. Shares have rebounded 3.5% since the capitulation point but could still be an attractive long-term investment. Earnings are expected to grow by 6% in 2013 and 11% next year. I think the longer-term upside could be very strong on demographic trends. One of the greatest desires expressed by retiring boomers is the ability to stay independent in their own homes. With its home monitoring and security technology, ADT is positioned to be able to capitalize on the wave of aging retirees.
Southern Copper (NYSE:SCCO) is down 27% this year on weak copper prices as investors fear the commodity super cycle may be coming to an end. The shares trade for 14.9 times trailing earnings, a 10% premium on the industry average of 13.5 times earnings. The company is said to be finalizing a new environmental impact study that could eventually lead to its winning support from local groups to reopen the $1 billion Tia Maria mine in Peru. The project has been shuttered since 2011 on opposition of water use which may be allayed by pumping in sea water to the site. The project could produce an additional 120,000 tons of copper a year, adding almost 20% to the company's current capacity of 640,000 tons. Any favorable developments on the project would be a positive catalyst but could still be a ways off.
The shares have not seen a capitulation point since September of 2012 when the price dropped 2.7% on 6.5 million shares. While shares rebounded 20% off of the panic selling, they have since fallen further this year and may not have reached their bottom.
Just one indicator in your toolbox
For long-term investors, marking a capitulation point is only one tool you should be using. It should not replace solid analysis in a stock and development of a long-term outlook. Instead, use it to help you decide your buying and selling points. If a stock has come under selling pressure but only on average volume, it may have farther to fall until all the short-term investors are shaken out. If your conviction on the upside potential is shaky then it might be time to cut your losses. Conversely, if shares have hit above average volume on the downside then there may be more support ahead.
There is no guarantee that a stock seeing abnormally high volume on a down day will not fall further but quantifying the process helps to remove emotion from investing. Let other investors panic and sell out of a strong name while you hold to your conviction and wait for the rebound.
Disclosure: I am long JOY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.