Are stock prices really the sum of clich้s?

By Brady Willett
As stock market prognosticators do their best to try and figure what, if anything, the recent action in the markets means, invariably three terms are getting massaged: oversold, capitulation, and confidence.

Oversold
 The term oversold is particularly popular among technical enthusiasts.  That said, the basic concept is that once the markets get beaten up badly it is inevitable that buyers will swoop in to collect the remains of the dead.  Given that all the major U.S. markets have dropped for four weeks in succession it is unsurprising that the term 'oversold' is being mentioned often.   

"The sellers are starting to worry that they're making sales into an oversold market."  Jon Baranko, director of trading at Strong Capital Management, which oversees $50 billion

And yes, from time to time people like Mr. Baranko use the term 'oversold' in a fairly asinine manner. 

Capitulation
Another term making the rounds today is 'capitulation'.  This word is used to speculate on the markets 'bottom' (yet another word making the rounds).  The logic goes that until the markets see capitulation selling, or when traders are clawing each others eyes out trying to sell stock in a market void of buying, prices will not firmly rebound higher.

"You could see capitulation in the equity market today. The only place to hide is in gold or in bonds".   Bond trader at the Chicago Board of Trade (June 14)

"Capitulation" is not defined by price decline alone.  "Capitulation" is primarily defined by sentiment."   HD Brous & Co.

Confidence
 Lastly, 'confidence' is perhaps the most oft used word by investors and commentators today.  As prognosticators try to enlighten others as to why stocks are falling variances of the term 'investors lack confidence in the markets' are being pandered about as the gospel.  The premise being that terrorism, accounting, and double dip fears are impacting investor confidence.

Side note: when considering that terrorism is a real cost to American businesses, that loose accounting standards inflated profits for many years but may not continue to do so in the future, and that the U.S. economy has already begun to slow off its 1Q02 pace, 'confidence' is perhaps the wrong word choice to describe investor apprehensions surrounding stocks. For certain, 'reality' is more fitting.
 
How The Summer 'Doldrums' Got Exciting
That excitment in stocks seems to be rising even as prices drop has a great deal to do with expectations of 'oversold' and 'capitulatory' conditions: yes, prices have fallen, and we have been led to believe that the drops have been quite 'dramatic' considering the U.S. economy is on the mend.  However, realistically the action has been simply methodical – a slow drip has been called a downpour because consistent selling in the markets has become almost hypnotic.  In other words, until prices rebound people can't stop looking at the tape...

Has Capitulation Passed By?
 Anytime investors are buying more put options than call options the stock markets usually act extremely pessimistic.  To be sure, the put/call ratio has been above 1 only 5 times this year – 3 of which occurred during the last 3 weeks.  And although the last 3 weeks have been choppy they have all been negative.

That said, the put/call ratio matched a yearly highly last Friday, and the last time the p/c ratio reached 1.15 (Feb 15) the markets quickly rebounded higher.

Moreover, the VIX index, climbing steadily for much of the last month, also closed at a yearly high on Friday.


What do these stats mean?  Well, either that currently 'oversold' conditions will bring about another 'bear bounce' (dead cat bounce) or we are that much closer to 'capitulation' (panic) selling which forces the markets below last Septembers' 'capitulation bottom' and forms a new 'bottom' in which stocks can 'consolidate' and 'trend' higher.
 
In other words, until 'capitulation' is actually categorized as such (in hindsight), there is no magic number that foretells of a pending 'trading' rebound for stocks. 
 
A Different Take
It is difficult to buy into the 'capitulation' argument.  To be sure, September 2001 supposedly marked an historic 'capitulatory' 'bottom' yet the Nasdaq came close to testing its September lows last week. Moreover, it is difficult to concur that the markets are 'oversold'. Rather, and even though stocks could soon 'bounce', the markets still appear to be 'overbought'.

Think about it: all of the gains in stocks since 9/11 have been made possible by progressively optimistic 'expectations'.  First, America had to acquire the resolve to fight terrorism – mission accomplished.  Next, the American economy had to rebound from a period of negative growth – mission accomplished.  Lastly, in order for the markets to continue to rally consumers had to keep spending and businesses had to start making some profits and start spending.

Contrary to the popular axiom -- 2 out of 3 is bad!

Indeed, the U.S. consumer, as witnessed by weak retail sales and preliminary confidence numbers, is already showing signs that they are tired.  Moreover, despite an improving economy businesses have not yet re-acquired much pricing power and/or shown any signs that they are willing to increase spending or higher new workers.  Accordingly, and less than two full quarters into the turnaround, the U.S. economy is threatening to double dip. 

To reiterate some of my previous sentiments, if the U.S. economy double dips there is no predictable bottom.  Quite frankly, the predictable Fed, the anxious U.S. consumer, and the bubbling stock markets have already constructed the necessary conditions for an economic rebound.  As such, and to implant yet another popular phrase, in the case of the U.S. economic rebound – it is now or never. 

By late 2002 if corporate earnings are not rebounding strongly forget about 'oversold', 'capitulation', and 'confidence – stock prices will be, and deserve to be, significantly lower than they are today.

 September 21, 2001 – Intraday
Dow: 7926.90
Nasdaq:  1387.06
S&P 500:  944.75

Brady Willett
BWillett@fallstreet.com
www.wallstreetwishlist.com

June 20, 2002