The Point of Capitulation
After watching the DOW drop to a new 7 year low last week, many investors are left wondering whether or not we have reached the point of capitulation. Over the last year we have experienced the extreme conditions that crowd forces can exert on the market. Since capitulation is based on fear and not quantifiable justification, it leads me to believe that we have not yet hit the point where all of the sellers have been stricken from the market. The fact of the matter is that not everyone has thrown in the towel – and rightfully so. So, if after watching the DOW fall to its 7 year low of 7800, I am not convinced that we have reached the point of capitulation, then where and when do I preview this occurring. At this current moment, I believe there are too many negative forces dragging down the market. I am not concerned about the value investor base, day traders, or even hedge funds for that matter. My assumption at this point in time is that a majority of the ‘sky is falling crowd’ have already abandoned all hope of the DOW at 14,000 or the S&P at 1500. They are most likely sitting on the sidelines, waiting for the market to stabilize before they convert their 10 year notes, TIPS, and gold bullion back into equities. While I believe the market is significantly undervalued, and primed for value investors to pick through what is left, I still remain very wary that all short interests have exerted their full force. Security analysis is critically important, particularly within the Corporate Bond and Convertible markets. There are still several critical activities that must occur in order to set the appropriate expectations and declare a “bottom”.
1. Consumption stimulus: In order for the market to price in a rebound, there must be some reasonable expectation that consumption will rebound. Thus far, it appears as though consumers are hoarding their cash for fear that they will continue to face mounting losses in fixed asset classes and marketable securities. Rightfully, cash reserves are not being used to consumer durable goods and is being reserved for the necessities – so much for buying a car or a home any time soon. Traditionally, consumption stimulus has been achieved through expansion of credit. Given that interest rates are equivocal to their 7 year lows and GDP is expected to decline quite rapidly, it leads me to believe that interest rate reductions were ineffective and late or money supply conditions are no longer the current driver for economic expansion.
2. Fixed Asset Stability: Despite nearly 40% drops in housing prices (some areas) over the last year, housing valuations continue to decline. Despite low interest rates, tightened credit standards have reduced the size and scale of the consumable credit pool. Those that had high quality credit ratings are stuck with a harsh reality of whether or not to foreclose on their home and start over (locking in losses) or to stick it out. Even those who are in healthy credit positions are facing a major moral dilemma when determining which options are available. The elasticity of foreclosure and housing prices is an important relationship that I have not yet analyzed. My expectation would be that initial credit defaults would lead to foreclosures, then declining home prices, and then continual waves of default creating a downward spiral trend similar to the one that nearly took down our banking sector as credit derivative positions were unwound. Regardless, MBS’s and tranches must be unwound so that the underlying homes can be purchased and sold. For housing valuations see Case Schiller Index online. In the interim I would expect the government to leverage the size and scale of FANNIE MAE and FREDDIE MAC to purchase conforming loans, eventually transforming the two organizations into regulatory bodies that set underwriting and securitization standards.
3. Political Stability: The faster the President Elect Barack Obama can begin his term the better. As a meritocratic pragmatist, my personal preference is not to identify with one party over another, but to clearly outline the net effect that political stability will have on the market. The primary driver for markets and the efficient pricing of risk is setting appropriate expectations and delivering results. Much like economic metrics, the political landscape also plays a critical role in setting the expectations of market participants. At this point, who the president is matters much less than the pursuit of the transformational actions that are required to stabilize the system. It is disheartening to know that we are relying on politicians and not capital experts to assess the current situation – however flawed the banking and advisory ideologies may be they are the best options available.
My intention is that my views will help others to think about problems on a broader term, often outside of the microcosm that is each individuals perception. Please comment if you have any ideas comments, or questions that contribute to the assertion that I have posted above.