What do market bottoms and capitulation look like?

Is this the bottom?

When we were kids in a car, we'd constantly ask: "Are we there yet?"

The answer was always no. A little farther.

Once we gave up and stopped asking, falling asleep in the back of the car, then we arrived.

I ran the #1 fund in 1999, up 495% that year.

But my prouder moment was leading a hedge fund up 20% vs a down 40% market the following year (2000). I called the semiconductor cycle right and that multi-billion dollar trade drove our outperformance.

Yet, I look at my time at that hedge fund with regret for not speaking up more.

Because I had been through so many semiconductor cycles, I had amassed far more experience with downturns and upturns, with all their euphoria and desperation than the average analyst or even vs an experienced portfolio manager.

In 2000:

We were coming off the longest bull market in history. The NASDAQ went down 40% in 2000.

Everyone was watching for the Fed to blink, to change their mind and stop raising rates.

Each time the Fed slowed their raises, the market rallied. Then companies reported. Results were worse.

Our hedge fund was designed to avoid this cognitive dissonance. We as analysts were tasked with speaking regularly with management and relaying that back to the head of the fund. He would trade on real information.

Problem was, he was human.

So he figured, management just hadn't seen the upturn, and he'd go long. Stocks rally before recessions are over, so he'd get in front of it. We got our head handed to us again and again.

This was the TOP hedge fund of the 90s.

The chart below shows what happened.

The grey area is the recession. The blue line is the market. Aside from the decline, notice all those big head fake rallies. Want to learn more about how to spot these tricky bear market rallies? Check out my blog Dead Cats, Falling Knives, and False Charges.

The recession, two quarters of negative growth, started officially in early 2001. By that time NASDAQ was already down 40%. You can see what happened after that first 40% decline.

The Semiconductors we shorted in June 2000 went down 80%+ in 3 years, bottoming in July 2003.

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What about my previous employer, where I ran the #1 fund?

Their system also would have avoided any losses in 2000.

The system, simply put, was to buy what was going up. In 2000 this was consumer staples and energy. They went up BIG. How did the firm do? Dismally.

They were human.

After making so much money in tech for a decade, they identified themselves as great tech investors, so they kept buying and owning tech, even when it went down. If they had followed their strategy of only buying what is going up, they would have bought consumer staples and energy and made money, not just outperformed, but made money in 2000, even without shorting.

So here we are today.

The markets are excited about a potential Fed Pivot.

A Fed Pivot would mean the Fed not raising rates, or raising at a slower pace.

Our "recent memory" is of 2010 and 2011, when the Fed tried tightening by reducing the size of their balance sheet, then markets declined and the Fed said "just kidding" and reversed course. So, it's only natural to think the Fed could back off their tightening and we could resume the bull market. That's why we've had these bear market rallies (in addition to being near term oversold).

Why is this different than 2011?

Just like semiconductor downturns, there are short fast ones, and there are long protracted ones.

How do you tell ahead of time?

When you layer cyclical and economic cycles on top of each other, the downturns are deeper and longer.

2010 and 2011 were after the 2008 financial crisis, so our economy was slowly getting back on its feet. Yes, it could have been like the double-dip into the great depression we saw in the late 1930s when the Fed raised rates too much too early, but in general, we were just getting started.

2022 is after the longest bull market in history.

More importantly, we haven't seen the real effect 6 months of Fed raises.

People will decide they can't afford a bigger house (or the one they are in using a variable interest rate)
People will defer buying a new car/washer/dryer with higher interest rates
Companies will decide credit is too expensive and rather than borrow to expand they will go through layoffs to cut costs

We haven't seen the full impact of these higher rates because they are new, and there's a delay. It's the next time someone is faced with a decision of buying on credit, taking out a loan, and expanding their business that we will see the impact.

These pull-backs in demand may help inflation subside, but we are unlikely to avoid a recession on the way to curbing inflation.

Yet, the biggest question I get is: Are We There Yet? Is It Over?

And capitulation?

We are not there yet if people are still asking if we are there yet.

Charts like this float around showing that markets rally before earnings improve. My issue today is we have only just begun to see earnings declines. Our economy is still growing, though much slower. Recession is two quarters in a row of negative growth. We are not there yet.

I saw capitulation and bottoms in fast succession in the semiconductor markets. It was like an MBA in recessions, because the industry had one every few years when they went into overcapacity and demand went negative.

Reaching capitulation and market bottoms is like going through the 5 stages of grief.

Five stages of grief in markets:

1. Denial - "Inflation is transient. Tech and innovation are so exciting. You have to own incredible companies. Their demand is so high. They are supply constrained, so a slowdown won't hurt."

2. Anger - "These people don't understand the long term potential of tech stocks. They are idiots panic selling. I can't believe what this is doing to my portfolio. If only people really understood how bright the future will be."

3. Bargaining - "Now, see that rally off the bottom in June? That was oversold. People capitulated because they can't deny the growth and earnings potential of these tech stocks."... after the roundtrip to the same low in October? "Now we really have hit bottom, let's rally these tech stocks before their earnings."

4. Depression - "Wow those were terrible AMZN, MSFT, FB, etc earnings. I'm going to hide in a hole and sell some. I'm crying right along with Jim Cramer on CNBC, but not as publicly. Maybe if I am this depressed we are near a bottom. I definitely feel low. This is capitulation."

5. Acceptance - "Tech stocks are in decline. Look at all those layoffs. They pulled forward years of demand in 2020 and 2021. They are huge companies that are past their prime. I wouldn't own a tech stock if you paid me. I'm buying Starbucks and some green energy companies. Tech won't grow more than 5% going forward. "

We are clearly not at #5 yet.

Every semi-cycle, at the bottom, I waited till no one would own a single stock, not even Intel, the blue-chip of semis. Then, and only then, had we capitulated.

Each cycle, there came a day when investors told me they wouldn't get near Intel with a 10-foot pole and semis would never grow more than 5% going forward.

If there's no one left to sell, the next move is a small buy. Then upward momentum starts, as price action improves.

But first we have to get to where there's no one left to sell.

By the way, "no one left to sell" is a gross oversimplification (by me). Someone is always holding the shares. The last growth investor has sold his or her last share of formerly growth stocks to value investors for 80% off. That growth investor then has a portfolio of larger safe slow stocks. So it feels like everyone has sold, because the last person betting on growth has thrown in the towel.

Capitulation feels like a resigned acceptance that markets will never return to growth.

How do we know when capitulation is near? What are the signs? What happens before capitulation?

Like an earthquake there are tremors before the big one: FX, British bonds, inflation and now options markets have all had tremors.

They are typically in various corners of the markets out of plain sight. Why? Because they’re the unintended consequences and second order effects policy makers and markets don’t expect.

Capitulation isn’t where everyone but you gives up. It’s when you stop asking if markets have capitulated because you’ve given up too. Mathematically speaking if everyone bought at the low it wouldn’t be a low. You’ve capitulated. In the semi market, right before a downturn (like today when we are forecasting and expecting a recession, but the numbers are not negative yet), analysts would call me saying they didn't expect too bad of a downturn, so the market would "look through it" to growth on the other side.

I remember when the head of IR from Micron spoke of a "period of digestion", like they ate too much. I asked him why not just say a downturn is coming because we all know it?

He said: "Because, Emmy, its my job to support the stock price, and most analysts haven't been around more than 5 years, so they don't remember the really bad downturns."

Sound famililar?

When these analysts would call me about the market "looking across the valley", I'd remind them:

There's a big difference between seeing valley and being halfway across bridge and panicking because it’s so high. We want the “upside” of buying low without the pain of jumping off the bridge in panic when we see how deep the valley is.

How deep were those valleys?

2001-2003

Dot com bust, huge layoffs, Enron and Worldcom scandals, Arthur Anderson bankruptcy, 9/11, and finally public tech stocks selling for less than their cash on hand by summer 2003.

2008

AIG, Fannie Mae, Freddie Mac rescues, Bear Stearns and Lehman collapse. GE risked not making payroll because short term T-bill market seized up. My regular friends were asking if their bank accounts were safe.

Fear everywhere

That’s capitulation.

We don’t want to face the fact that real capitulation shakes everyone’s confidence.

Capitulation is the market un-training our buy-on-a-dip habit

Warren Buffet has said it's hardest to have cash when you need it.

Investors can run out of cash buying on every dip on the way down.

Charlie Munger says one of the most valuable things you can do as an investor is to sit on your hands (of course, that depends if you are confident with your positioning).

This is NOT to say we won’t have bear market rallies which can take the market up 30-40%. In 2000-2003 there were multiple rallies over 20%.