Sweet Surrender

The market's relentless fall has pushed investors to the breaking point. Hey, could this be the moment we've been waiting for?

By Adam Lashinsky

Capitulate To cease resisting; ACQUIESCE, SURRENDER.

Lately every stock market victory, each of those heady, triple-digit jumps, has been fleeting--lasting a day or few at most before grim reality sets in again. Maybe you win a battle, but it's tough to forget about the larger war: the 2 1/2 years of bone-crushing losses that have decimated portfolios and demoralized investors. And for good reason: Retirements have been pushed back, college funds emptied--all while disgust at corporate America makes us ever queasier. At this point, many investors are ready to give up entirely, fleeing from stocks as if they were laden with the West Nile virus.

Finally!!

In one of the great historical ironies of the stock market, such white-knuckle panic is exactly what we've been waiting for. There's even a Wall Street term for it, borrowed from the battlefield: capitulation. It's that moment when fear has so thoroughly seized the general investing public that irrational pessimism takes hold. It's that desperate instant of mass misery when hope and reason are cast aside and irrepressible selling takes over. It's that psychological breaking point that every trader and talking head is currently mumbling about. Trouble is, that magic moment is almost impossible to pinpoint--at least not until long after the fact.

So why, you ask, is capitulation a cause for celebration? What kind of sadist would start singing hallelujahs after everyone else has gotten thoroughly wiped out? The kind you find on Wall Street, for one. Market watchers say that when everybody else has given up, that's the time to get in.

So here's the awful good news: There are signs that it's near. As when sportscasters, like Monday Night Football veteran Al Michaels, start bragging about their short-selling prowess. And when prominent perma-bears, like short-seller David Tice, are suddenly media darlings. And when formerly bullish brokerages run newspaper ads featuring full-page photos of sharp-toothed, snarling bears. All we need now are crop circles.

The subtle, if ugly, undercurrent to understanding capitulation seems to be a masses-are-asses approach to investor psychology. In other words, if the horde thinks one thing, then the opposite is likely to be true. Nowhere is this clearer--on the upside as well as the downside--than in measuring money flowing in and out of mutual funds. "Fund flows are the ultimate contrarian indicator," says Charles Biderman, president of TrimTabs.com, a firm that tracks fund data. During the first four months of 2000, for example, a combined $119 billion moved into U.S. equity funds, twice the rate of the previous year. That, of course, was the very peak of the market's long bull run. The reverse is happening now. Investors yanked $18.7 billion out of funds this June alone and removed another $47 billion in July, an all-time one-month record. The mass exodus, say veteran fund watchers, could signal a turning point.

Another telltale sign of capitulation is the VIX, an index that tracks volatility by gauging demand for put options. Investors buy them as a form of downside protection. The higher the VIX, the more panic in the markets--and the greater the chance that investors have given up hope, taken their money, and gone home. "The psychological impact the VIX has when it goes over 50 is that it tells traders the market has been way oversold," says Lillian Seidman, a partner with options-trading specialist firm Miller Tabak in New York City. It just so happens that the VIX shot over 50 on July 23 for the first time since 1987. That coincided with a recent low in the Dow Jones industrial average that was followed by a 1,034-point, six-day rally. That rally didn't stick, though, raising the fear that the VIX's high-water mark was more a trading opportunity than a true bottom.

At its core, the VIX is a statistical measure of emotions, and emotions are a major factor signaling capitulation. "I'm not a big fan of gold, to say the least," says Timothy Leach, chief investment officer for the Wells Fargo unit that manages $38 billion for wealthy clients. "But I've had some people in my group start to seriously advocate gold investments from an equity point of view, and I'm thinking, 'Boy, this is the sign of the bottom!' " Another clue, Leach says, is when affluent individuals who've been patiently building wealth for years start barking to their brokers "Just sell!" Their mounting disgust is making them discard the disciplined approach that helped them get rich in the first place. Finally, Leach checks in on his competition: A definite sign of capitulation, he says, is when the former doormats of the investment world get cocky. "When bond managers are feeling [optimistic] as a group, it's time for bonds to get killed and for equity guys like me to start feeling good," he says. (Who knows what sort of predictive value wishful thinking has....)

Other, more traditional measures of capitulation also indicate that a market bottom may be near. High trading volume, for instance, can signal irrational behavior. In the five trading days from July 19 to 25, when the Dow hit its recent lows, more than 20 million shares changed hands each day--far more than typical daily volume this summer, in the low to mid-teens.

But forget the statistics for just a moment. TrimTabs' Biderman thinks he spotted the ultimate sign of capitulation in early July, when the media turned ardently against Wall Street and the people who profited from it. "Prior to July 8 there were virtually no cartoons about CEO crooks, which now you see every day," he says. "It's the reverse of pre-2000, when, if you believed what you read in the media, you couldn't lose."

The only problem: If you follow that logic, any story about the signs of a bottom right now should be taken as one screaming sell signal. Oh, well.