John Hussman: Waiting for Investor 'Capitulation'

Excerpt from the Hussman Funds' Weekly Market Comment (6/23/08)

Though we've seen a few strong rallies since last year, they've been fairly high-risk advances in that they could very well have gone the other way, because lower-risk conditions weren't generally present. We did observe volatility spikes and falling interest rates at the August, January and March troughs, but valuations remained rich, market action off of the lows was typically not compelling, and investors have been largely in denial about recession risk and the continuing onslaught of foreclosures and credit losses. “Capitulation” would mean investors accepting those risks, and also believing that they will only get worse.

My impression is that we will eventually observe that sort of capitulation, hand-in-hand with broad recognition that the U.S. economy is in recession. That sort of capitulation may provide some opportunity to reduce our level of defensiveness, particularly by removing the short-call option side of our hedge. Still, we should not assume that the next significant capitulation will be the last. Bear markets typically involve a series of them (e.g. initial weakness on no news or only fears about interest rates or inflation, initial earnings disappointments, initial evidence of economic weakness, consensus about recession itself, consensus about the deepening of the recession, and eventually the mother of all bear market lows – complete loss of hope and a panic to cut deepening losses and “just get me out”).

From the standpoint of capitulation, last week's decline was actually very orderly, and hardly caused the CBOE volatility index to budge. When we see the VIX spike to the mid 30's or 40's, it may become useful to survey opportunities to assume greater market risk. So far, however, the VIX makes it clear that investors are taking recent losses very casually. The following charts are from Carl Swenlin's nice Decision Point site.

Comments

[iThinkBig]

The good news is that the U.S. has had big gains in communications technology and food output compared to the Great Depression meaning the country can recover in a few short years.

The bad news is the added crap the middle class particularly small businesses (49% GDP) will have to go through to rebuild jobs. We are getting no love or help from the banking system, investment community or government and are on our own against the predators from government or utilities. The rapid shocks of boom BUST economy are overwhelming the 49%. That is why Wall St. and Government are scratching there heads looking at total GDP and over-all market conditions while Main St. is screaming for blood.

Government had better rub peepies up there on the hill on subsidies for skilled job creation in the higher ed market and energy and RIGHT NOW. Bummer that this is an election year and interfering with creation of common sense policy until after the election (and then a quarter out from that when new people get in). For these reasons I speculate depression, no job creation floor (minus healthcare which I am in as a business and small bump in government jobs/defense spending) to cushion the freefall.

That says to me a full contraction to -20 GDP in three year cumulative or the classic definition of depression. The wild card is Washington with rampant corruption and socialist momentum of politics so I make investment decisions based upon THAT.

[Whidbey]

John, you fail to mention what will drive the market to capitulation. In most cases it is the loss of selling pressure, and the belief that equities have little value as compared to such things as cash, real estate, commodities etc. That may be along ways away. As you know cash has little earning power and is being eroded by inflation, real estate is likely some years to becoming a "BUY", and commodities might be the sole asset of value - if and only if you believe growth in a few global economies will continue. You seem too literary in your analysis. Capitulation may be many long years away.

[icandoitdon]

whidbey has it right. those looking for capitulation are likely to never see it. this is a unique environment, with large variations in almost all asset classes. cash pays nothing. commodities are a speculative bubble. real estate is still declining and will not revisit old peaks for years. credit has dried up. economic growth is ebbing everywhere. consumers are on life support. with that backdrop, low returns are likely for the foreseeable future in nearly all asset classes. winners in this environment are more lucky than good.

having said that, all could change quicky if oil were to recede significantly. when/if it breaks ill be investing with both fists...until them i'll stay where i've been for most of the last year....on the sidelines waiting to pick through the wreckage.

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