Meltdown 101: What is market capitulation?

[October 18, 2008]  NEW YORK (AP) -- During last week's nosedive in the stock market, as some investors frantically pulled their money out of stocks, the veterans of Wall Street started throwing around the word "capitulation."

In the context of the market, it's a term that means the bulk of investors have given up and sold everything they can - and many experts say it's the best time to buy.

So, has the market capitulated? Will it head higher over the coming days and weeks?

Here are some questions and answers about capitulation, including what it tells us - and doesn't tell us - about the direction of stocks.

Q: Is capitulation good or bad?

A: Both.

When it's happening, it's bad. Panic abounds as investors watch their portfolios plunge and bail out at low prices. And those who sell low and don't buy back in ahead of the market's upswing are often left with big losses.

But capitulation can turn into a positive thing, because once the purge is over, it's often a great time to buy. Prices are cheap, and there's a lot of money on the sidelines ready to pour back in.

Q: So why isn't everyone gung-ho about stocks right now?

A: People are still skittish about individual stocks. That's particularly the case with financial stocks, and with shares of companies struggling to finance operations at a time when banks are hesitant to lend money.

Also, no one is positive that capitulation has fully happened yet. That's the thing about capitulation - you don't know for sure it's happened until after it's over.

And even if capitulation has happened, the market could swing erratically at these levels for some time before heading higher again. Even Warren Buffett in his New York Times guest column Friday wrote that while he tends to "be fearful when others are greedy, and be greedy when others are fearful," he "cannot predict the short-term movements of the stock market."

Q: What are the signs of capitulation?

A: The signs are big market plunges, high trading volumes and extreme levels of fear.

All these criteria were met last Friday, said Alfred E. Goldman, chief market strategist at Wachovia Securities. That day, the Dow Jones industrial average fell nearly 700 points to just 60 points above the low that Wall Street tumbled to in 2002 during its last bear market. Then, it swung dramatically higher.

"In my 48 years as a student of the markets, I've never seen fear at greater levels. And that's including Black Monday on Oct. 17, 1987," Goldman said. "What we thought was capitulation in the '60s, '70s and '80s is a tea party compared to what we've had."

Q: But that doesn't necessarily mean it's all over, right?

A: Right. No one knows. It's always possible that fear could hit higher levels and trigger selling again - particularly since the financial system is coming off its highest levels of leverage ever, said Quincy Krosby, chief investment strategist for The Hartford. Leverage is the degree to which a company is operating on borrowed money.

Q: What else factored into last week's drop?

A: It's undeniable that fear played a huge role. But there are other factors, too, like margin calls and redemptions - which are only indirectly tied to fear, and also related to leverage.

A margin call is when a broker tells an investor to deposit more money into his account because the securities he bought with borrowed money fell to a certain point. When that happens, the investor usually has to sell something else, like stock, to get cash.

A redemption is simpler. It happens when an investor in a fund - like a mutual fund, which pools together money to invest in stocks, bonds and other assets - tells the fund he wants to cash out. To make up for that loss, the fund has to sell some assets, like shares of stock.

[Associated Press; By MADLEN READ]

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