The origins of the hare-brained "capitulation" fallacy - 5-Oct-2008 - Generational Dynamics

As I described a few days ago, pundits, analysts and investors are actually all smiles these days because they like what's happening on Wall Street.

They're hoping for "capitulation," where the markets sell off wildly, and then the market starts going up again. This is exactly the mistake that investors made in 1929, and it leads to what I've been calling the "Principle of Maximum Ruin," where everyone gets back into the market, only to lose money again -- the maximum number of people are ruined to the maximum extent possible. In 1929, the markets fell for four years - to 10% of their peak value, by 1933.

In this article, we're going to explain why investors have the fantasy that a "capitulation event" will cause the market to rise again.

The "capitulation" concept is a complete misreading of what happened in 1987, in what I call the "False Panic of 1987."

To understand it, begin by looking closely at the following table, with data from my Dow Jones historical page, which shows the lead-in to the Panic of 1987:

As you can see, on August 25, 1987, the Dow was at 2722, the high for the year. At that point it started falling at the rate of a point or two every day, and then on Friday, Oct 16, it fell 4.6%.

I actually have a personal memory of that weekend. The market had fallen roughly from 2500 on Tuesday to 2200 on Friday, and it was being discussed on television. My memory is of an old guy (who I now realize must have been around 5-10 years old in 1929) saying the following: "The market may fall a little more, but the next 300 point move will be in an upward direction."

Then on Monday, October 19, the market fell 500 points, or 22.6%, all in one day, to around 1700.

Now you can imagine the psychology at the time. The people in charge were survivors of the 1929 crash. As I've described in conjunction with the "58-year hypothesis," these are people 63+ years old who realize that (1) the pattern from 25-Aug to to 19-Oct-1987 was almost identical to the pattern 3-Sept to 28-Oct-1929. These people would recognize the similarity, but younger people would be almost entirely oblivious to it.

The 1987 panic must have been pretty humiliating for the Silent Generation senior managers who had led the panic. They had told the younger people -- the Boomers and Generation-Xers -- that a crash was coming, and no crash came.

Today, the Silent Generation is gone, and the Boomers and Generation-Xers are running things. They learned completely different lessons from what happened in 1987:

The "capitulation" theory comes entirely from that event, and a couple of similar but much smaller "capitulations" that have occurred since then. In other words, the pundits and investors believe that when we have another day like October 28, 1987, a "capitulation," then the market will have truly reached bottom, and will start going up again.

So it's good to understand that even people who disagree with me about a coming stock market crash still agree that "something" is going to happen -- something like the 22% plunge that happened on 28-Oct-1987. And this is important -- mainstream analysts agree with me that this is what's going to happen.

So mainstream investors agree with me that some kind of panic event is going to occur. Where we differ is what happens afterwards:

I realize that I just quoted the following a few days ago, but you can't possibly read it too many times. It's from John Kenneth Galbraith's 1954 book The Great Crash - 1929. It describes how the "Principle of Maximum Ruin" played out in 1929:

"A common feature of all these earlier troubles [previous panics] was that having happened they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune.

The fortunate speculator who had funds to answer the first margin call presently got another and equally urgent one, and if he met that there would still be another. In the end all the money he had was extracted from him and lost. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. ... The bargains then suffered a ruinous fall. Even the man who waited out all of October and all of November, who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market, and who then bought common stocks would see their value drop to a third or fourth of the purchase price in the next twenty-four months. ... The ruthlessness of [the stock market was] remarkable." (p. 108)

In fact, anyone with any sense at all can see that the market can't start going up again, since corporate earnings are still falling.

As regular readers know, for the last few quarters I've been posting the table of S&P 500 average corporate earnings estimates, based on figures from CNBC Earnings Central supplied by Thomson Reuters. These tables have shown sharp falls in corporate earnings estimates from week to week.

I haven't posted such a table for a while, because there's been so much going on with the various bailouts. However, the third quarter ended last week, so this is a good time to catch up:

As you can see, the third quarter is proceeding just like the last few quarters -- high hopes and high estimates of rising corporate earnings are dashed as actual earnings come out.

The significance of this to the current article is that with the fall of earnings, price/earnings ratios (valuations) are rising. They've been at very high levels since March, and they continue to be at the astronomic levels of 24-25.

What this means is that the market can't possibly start going up again. The computerized trading programs target a valuation level of around 18 (as I've explained many times, and even that level is way above the historical average. The P/E ratios have nowhere to go now but down, so the hare-brained "capitulation" fantasy can not and will not have anything like the effect that people are dreaming of.

Generational Dynamics Web Log for 5-Oct-2008
The origins of the hare-brained "capitulation" fallacy

Web Log Pages

	Generational Dynamics
	Forecasting America's Destiny ... and the World's

\| HOME \| WEB LOG \| COUNTRY WIKI \| COMMENT \| FORUM \| DOWNLOADS \| ABOUT \|

Generational Dynamics Web Log for 5-Oct-2008 The origins of the hare-brained "capitulation" fallacy

Web Log Pages

Generational Dynamics Web Log for 5-Oct-2008
The origins of the hare-brained "capitulation" fallacy