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Capitulation! Or is it?

Key points at a glance

  • People interact with each other in the equity market. Depending on the equity market cycle, sentiment can range from euphoria to panic.
  • Recently, when we hit a new low for the year in October, the financial press suggested we had arrived at the negative extreme: capitulation.
  • What we are seeing is growing tension among many investor groups, but not quite capitulation. It’s even possible that the current market cycle will bottom out without going overboard.

In October, when the key equity indices hit new lows for the year, there were increasing reports of capitulation on the part of many investors. Is this true? Have swathes of investors thrown in the towel and given up on the prospect of equity prices rising in the future? From the point of view of behavioural economics this could certainly be considered a constructive sign of where the equity markets are headed. A sign that no small number of countercyclical investors are eagerly awaiting.

If all investors have a positive outlook and
position their portfolios accordingly,
there is little scope for further price gains.
Conversely – if outlook and sentiment is poor
and many investors sell their stocks – then that’s a very different prospect
for future price gains!”

Christian Schmitt

Readers will no doubt at some stage have seen a graph plotting the mental state of a typical investor at the various stages of a stock market cycle. During a bull market, optimism spreads, which in time can lead to euphoria. This positive sentiment is catching and generally spreads even beyond long-established investor groups. Greed, or rather the prospect of easy money, often become a hallmark of this phase. A perfect example of when we most recently saw the peak of a phase such as this was in 2020/21.

Inevitably, in every phase of excess there comes a point when prices no longer rise. While the first appreciable falls are generally regarded as an opportunity to enter at a good price, if prices fall further the mood can change over time to tension, concern and then later fear, frustration and finally to panicked capitulation. So where are we right now in this market cycle? Is blood running in the streets, as John D. Rockefeller once so brutally put it?

The way to make money is to buy
when blood is running in the streets!”

John D. Rockefeller

What is quite undisputed is the fact that we have passed the peak and are now in a more or less distinct bear market. Almost all major indices meet not only the criterion largely regarded as the definition of a bear market – a more than 20% fall from peak prices – but are also showing typical signs of a bear market, such as much more pronounced price movements, that is, in both directions, up as well as down. Market segments that led upwards movements in the preceding euphoric phase, are presently seeing prices fall the most. First and foremost of these are unprofitable technology shares as well as cryptocurrencies, prices of which have on average fallen around 75% from last year’s peaks. Consequently, we should expect a capitulation in these segments first.

Amazingly, apart from the immense falls in prices, there is hardly any sign of capitulation in the disruptive growth markets of recent years; nobody has given up the fight here yet. Belief in the inexorable progress of technology and the prospects of enormous future market potential continue to dominate talk among analysts and investors. This unshattered hope also remains evident in the capital flows into the best-known and most-popular products in this segment. Serving as a global beacon is the ARK Innovation fund from U.S. fund manager Catherine Wood, which, despite a 60% decline in value in the first ten months of the year, managed to bring in around USD 1.4 billion in new investor money in the same period. One popular triple leveraged semiconductor ETF from another provider has lost more than 80% of its value in the year to date but has seen no less than USD 6.3 billion in fresh inflows. Were it not for the negative symbol in front of the performance figures, we would think this was a case of euphoria, and certainly not panicked capitulation!

Does the broader market tell a different story? A regular source of information on this is, for example, the monthly fund manager survey carried out by Bank of America (BofA), which Bloomberg reported on in mid-October under the headline “BofA Survey ‘Screams’ Capitulation”. The article reads, “The sentiment on stocks and global growth among fund managers […] shows full capitulation.” It goes on to say, “[Strategists] note that investors have 6.3% of their portfolios in cash, the highest since April 2001, and that a net 49% of participants are underweight equities.” Sentiment has noticeably soured over the course of the year, which is also confirmed by other comparable surveys. But in view of the aforementioned figures we think it much too early to talk of a capitulation.

The biggest discrepancy among market participants remains between opinion and positioning. While it is very difficult if not impossible to hold a positive outlook given the plethora of flashpoints worldwide – many of them of a structural nature and tending to escalate – the strategic positionings and major movements of funds paint a different picture. European equity funds alone have seen significant outflows since the beginning of the year. In other regions of the world, inflows are only faltering now – even after a year in which inflows into equity funds were approximately on a par with the previous 20 years combined, according to figures from Goldman Sachs.

Adjustments in the strategic positionings of many investors
are more akin to a tanker
than a nippy speedboat.
Many seem to be persisting with “There Is No Alternative” to equities,
while the mother of all bubbles in the bond market is steadily losing air.”

Christian Schmitt

Another survey by J.P. Morgan similarly shed some light in September on the current equity positioning of professional investors. They were asked to put their current positioning into the context of their own historical positioning bandwidth. Only 13% were in the lowest three deciles – the majority were somewhere in the middle of their own historical bandwidth. Similar to the aforementioned 49% of market participants who are currently underweight equities, it bears repeating: this is not what true capitulation looks like!

Last but not least, what is your own positioning? Are you seeing signs of capitulation in yourself or your clients? Based on numerous conversations with clients and other market participants, the current mood among many investors can best be described as “tense”. The challenges are well known but the theory and experience in recent years have taught us that “sitting things out” is a genuine strategy or should be. At least it was in the past. After all, the world did not end, even during the global financial crisis, and stock market indices eventually broke new records.

However, “sitting things out” is not the strategy that ETHENEA pursues; we prefer action! In response to challenges, to hazards, to a changing world. We know that many investors tend to overestimate their own mental risk bearing capacity, and that investors often do not react until panic breaks out. We want to protect our investors against this as best possible by gearing our management not only to long-term but also to medium-term – and where possible even short-term – capital preservation.

So, will the big capitulation actually take place? We don’t know the answer. There is something to be said for “This time is different”. If one believes the predictions of economists, the current period of economic weakness will not bring much increased unemployment. And according to the latest quarterly report of the Bank of America, at least their American bank customers currently have much larger deposits than before the coronavirus pandemic. All good reasons why the falls in prices so far haven’t put investors under any increased psychological strain. That said, we remain rather cautious for the time being. The current year has ultimately shown that the falls in prices can be very severe at times – even without it coming to a capitulation.

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