Capitulation? Not Just Yet for the Stock Market

Jeff Cox, |Special to

Call the latest banks-inspired stock market selloff whatever you want, but don't call it a capitulation.

New York Stock Exchange (NYSE)
Oliver P. Quilla for

That's wishful thinking, according to many market pros, who say that despite Merrill Lynch's warning that banks are in capitulation and on their way to dividend cuts, the phenomenon hasn't spread to the larger market.

Capitulation is considered a point at which stocks are oversold and setting themselves up as bargains. That would be bad news in the short term as it would mean equities have fallen to perilously low levels, but good news in the long range in that it would signal a bottom and a point off which the market can rally.

Analysts and investment advisors say that a lack of sustained panic-selling indicates we're just not there yet despite Merrill's call on bank stocks, which have been the biggest weight on the broader market.

"I think capitulation's a strong word," says Brian Gendreau, investment strategist at ING Investment Management. "When you get a capitulation trade you get a feeling of total despair and darkness in the market where people just completely throw in the towel, and I don't see that at all."

One measure getting a lot of attention as the market heads toward testing new lows is the Chicago Board Options Exchange's Volatility Index , which moved up sharply on Friday but remains well off the highs it generally shows during a market bottom. A reading above 20 in the VIX generally indicates substantial volatility, but the number typically has reached the 30s during times of market bottom like in 2002 and 2003.

As long as the VIX remains in the 20s, analysts see little reason to expect a bottom.

"It's almost lethargic, this selloff," says Michael D. Cohn of Atlantis Asset Management in New York. "The one thing I'm always watching is the VIX, and the VIX hasn't really ratcheted up to any degree. When we were down (in stocks) at this level the last time we were in the 30s on the VIX, which created a capitulation bottom. This is by no means a capitulation bottom."

For investors, the lack of a real market bottom creates both peril and opportunity.

Some advisers actually are looking toward financials in the hopes that the battered sector can show leadership for a future rally. Merrill said it expects dividend cuts at Bank of America and Wachovia and some other large-cap regional banks.

"Some of the stuff that's been really badly beaten up is going to start to rally on the hope that we are more than 75 percent done with these writedowns," Cohn says. "We're heavily oversold and we're going to be heavily oversold today. I think by the middle of next week we could start to come up with some kind of constructive summer rally."

Look for some of those banks to start consolidating, as weaker ones find it impossible to raise needed capital and get absorbed by their larger competitors, says Quincy Krosby, chief investment strategist at The Hartford.

Quadruple Witching

"Have we reached the bottom with the banks? Probably not, until you begin to see how much money they all have to raise and more dividend cuts," Krosby says. "We suspect that with the regionals we're going to see consolidation, not necessarily banks going under, but consolidation."

That will be one of the ingredients needed to form a market bottom, she says, but there's no assurance as to when that will happen.

"The conventional wisdom is that when the dividend cuts come in more and more and more, that's when you start to see a bigger selloff and that leads to institutional investors coming in and taking longer-term positions," Krosby says. "But we may be in a place where conventional wisdom doesn't look. This recovery should have started by now in terms of share prices and the indices. This one is playing out a little bit longer. This is kind of a downturn in slow motion."

Muddied Market Offers Bargains

Investment advisers will always look for opportunities in time of uncertainty and this is no exception. But the lack of a market bottom in sight combined with the drop in stocks makes the effort a bit more challenging.

"There's no clarity in this market right now. When there's no clarity that provides opportunites. When there is clarity you've got a much more expensive market," Krosby says. "But when you start introducing the geopolitical fears, investors don't want to put money to work. ... This is a trader's market, a stock-specific trader's market."

Krosby believes oil- and gold-related plays look strong for now, but investors need to be cautious about concentrating in specific areas.

"The mantra is to be diversified as much as you can and do your dollar-cost averaging," she says. "The market is going to change direction when you least expect it."

Larry Edelson, an analyst at Weiss Research, likes consumer staples and natural resources, one of his specialties. But he cautions that a steep selloff could be ahead should the indexes test lows established by a proprietary analysis he uses and then continue to fall.

"Keep your eyes on 11,989 in the Dow and 1,294 in the S&P 500 at month's end," Edelson says. "If the Dow closes below the 11,989 number and the S&P falls below 1,294 we're going to see a heck of a washout. If they manage to hold those support levels, I would say now the worst is done."

Gendreau believes industries that were strong last year will boost the market this year, including export-oriented companies, as well as industrials, technology and materials.

But he worries that the market lacks a true leader at this point.

"Somehow I don't think financials are any more likely to lead the market up now than technology stocks were in 2001. It just doesn't ring true," Gendreau says. "It's not obvious what the catalyst is going forward. You're hearing this from an optimist."

Cohn, though, advocates "nibbling" at both financials and consumer discretionary, two sectors scaring investors in these uncertain times both for the market and the economy, where consumers are getting squeezed by soaring energy prices.

"We could have the type of rally that all the things that have been working for the last six or nine months--oil, agriculture, materials--those guys are going to languish, while we pull up the dead cats--consumer discretionary and financials. They're due for a rally," Cohn says. "These groups are so far oversold and some of them, given a scenario, will stop bleeding and are somewhat of a bargain here."

Those could be as good a place to start as any in this market.

"The market needs a major catalyst to push it on the upside range, to pull out of the top of trading range," Krosby says. "It can come from anywhere. It can come from Washington, it can come from the energy markets, but it definitely needs something."