When the last bull throws in the towel: Are we at market capitulation?

Many equity investors in India have now lived through more than one market cycle. This means that, when stock prices fall off a cliff as they have recently, such investors do not panic and desperately sell everything they own. Instead, they look at bear phases as opportunities to buy quality stocks for their long-term portfolio.

But even for such seasoned and sensible investors, knowing when to buy is not easy. You could end up deploying a substantial portion of your idle cash after a big fall, only to see even steeper falls ahead. Folks who waited for a 15% fall in the index from its peak to begin their buying at Nifty levels of 15800, for instance, have found the index tumbling another 400-500 points in short order with further damage looking likely. 

Yes, both a fundamental idea of where Nifty valuations should stand based on historical averages and a grip on key technical supports can help you time your buys better. These two articles we published earlier, on the Nifty 50 (and we periodically update the Nifty 50 technical outlook) and on market corrections offer indicative Nifty levels at which markets could bottom. 

But then, when bear markets enter their end-game, all rationality usually flies out the window.

Waiting for Capitulation

Capitulation marks the end phase that puts a full stop to a bear market and lays the foundation for the next bull phase. 

Capitulation is a phase when the sentiment turns so negative that the bellwether indices, stock prices and stock valuations plunge to levels which fundamental analysts didn’t even imagine! When Warren Buffett asks you to ‘buy when there’s blood on the Street’, it is the capitulation phase he’s referring to. 

Investors who have lived through the vicious bear markets of September 2001, October 2008 or March 2009, will tell you that stocks bought during such capitulation phases are today the biggest wealth creators in their equity portfolio!  

So, assuming you’ve been selectively nibbling at stocks or equity funds in the last few months and are waiting for the end-game, how do you identify the capitulation phase if and when it arrives?

When markets capitulated

Looking back at India’s stock market history with the benefit of hindsight, there were four big capitulation phases when equity sentiment, along with stock prices, hit rock-bottom. 

September 21 2001:  A market reeling from the dotcom bubble burst saw the Nifty 50 hit a low of 849 points on September 21 2001, after the 9/11 WTC attacks in the US fanned fears of World War III. From the dotcom peak of over 1800 points in February 2000, the Nifty crashed 53% before it made a bottom in September 2001.  

October 27 2008: The implosion in global growth in the aftermath of the US housing crisis, caused the Nifty 50 to crash from a high of over 6350 points in January 2008 to a low of 2252 points in October 2008. October 27 2008 marked the bottom of this bear phase, the markets falling 2.31% on that day. 

March 6 2009: After charting a weak recovery to over 3000 levels from the GFC crash, the Nifty 50 sank back to 2539 levels. 

March 23/24 2020: The realisation that Covid was attaining global proportions as a pandemic, with unknown implications for the economy, employment and public health, saw the Nifty crash to 7515 points and making a bottom 40% below its high of over 12300 points in mid-January 2020. 

The above capitulation phases are easy to spot with the benefit of hindsight. But how do you spot capitulation, when you’re living through it? We studied the four instances above to arrive at the following five signs.

Long drawn-out and brutal

Capitulation phases in the stock markets seldom get done quickly and sharply, like getting your wisdom teeth pulled. Instead, they tend to arrive after long-drawn pain that tests your patience much like a migraine headache.

Investors usually have to endure many months of losses and uncertainty about the economy and earnings, before a market correction gives way to full-blown capitulation. In 2001, investors had to withstand nearly 19 months of choppy market action during which the economic commentary was all doom and gloom, before the selling climaxed on September 28 2001 and the markets bottomed out to offer the buying opportunity of a lifetime. 

In 2008, investors had to live through 10 months of apocalyptic predictions between January and October, before the capitulation phase arrived on October 27 2008. The relief rally that followed also proved short-lived, and it took a second big dip in early March 2009 to put the full stop to this bear market. 

The most recent capitulation phase in March 2020 came swiftly, with barely three months elapsing between market highs of January 2020 and the out-and-out panic triggered by the onset of Covid in March 2020. But the fall in stock prices on this occasion was brutal, as even quality stocks tanked 40-50% within a few days.  

Given that every previous capitulation phase in the Indian markets has either taken 10-18 months to play out or has culminated with a 40-50% decline in the bellwether indices, we do seem to be some way away from a capitulation phase in the current context. Today, the Nifty 50 is about 8 months away from the recent high of over 18600 points. But it has corrected just 16% from its highs. A capitulation phase may require one or many more legs of sharp falls before the bears give up.

Dwindling retail flows

It is usually a sure-fire sign of a market bubble when retail investors are enthusiastically boarding the equity bandwagon. The recent bull phase between March 2020 and October 2021 had all the hallmarks of such a bubble, with demat accounts doubling and retail flows not only into MFs but also into IPOs, smallcases, and F&O hitting new highs. 

A capitulation phase requires the opposite. It is when newbie retail investors see their 1- and 3-year returns sink into red, sell equities in fear and flee to the safe haven of FDs, that bear markets tend to officially end. 

In 2008, net flows into equity MFs had turned negative (more redemptions than purchases) in the crucial months of September/October 2008 with the total flows into equity funds for January-October 2008 falling nearly 80% year on year to Rs 1926 crore.  

Given that there are more seasoned MF investors this time around and that SIPs are the favoured route to investing, the fall in retail MF flows may not be as sharp. But so far there are hardly any signs of retail investors developing cold feet, as net monthly inflows into equity MFs have been holding up in the Rs 18000 crore to Rs 19000 crore range, quite high by historical standards.

The only sign of retail investors starting to worry is in the decline in pace of new SIP registrations last month. A fall of at least 25-30% from these levels may be in order before one can call a capitulation phase in the current market. One-year equity fund returns have only recently turned negative while 3-year returns are in the double digits still.

Small-cap rout

If bear markets can be tough on index names, they can be brutal for the less-known names in the market. Small-cap stocks usually feature more retail shareholders than institutions and have patchy market liquidity. When markets crash, seasoned investors and institutions tend to look for bottom-fishing opportunities in bluechip names first, before getting down to the broader market. These two factors usually lead to small-caps suffering far more widespread and sharper damage than large or mid-cap stocks when the capitulation phase arrives. 

One way to assess how the long tail of the market is faring versus the top 100 names is to check the returns on the Nifty500 index vis a vis the Nifty50. In the 2008 market crash, while the Nifty50 lost 64% from peak to trough, the Nifty500 melted down by nearly 70%. In 2001, the Nifty50 fell 53% while the Nifty500 saw 70% of its peak value wiped out. 

In the current correction, many small-cap names in commodities, chemicals et al have suffered a rout. But the rout isn’t widespread yet with many small-caps also trading at 20 plus PEs. While the Nifty50 has lost 16% so far, the Nifty500 has declined about 18% from its October 2021 peak. Watch for a widening gap between the two, to gauge whether we’re near capitulation.

The fear gauge

Index providers offer us a handy tool to gauge if markets, on any given day, are in the grip of euphoria or paranoia. The India VIX, or Volatility Index, disseminated by NSE is deemed the fear gauge for Indian markets.  

This index captures the annualised volatility expected by options traders in the market over the next 30 trading days. So, a VIX of 21 indicates that traders expect the Nifty50 to move at an annualised rate of 21% in the next month. (More on the workings of the VIX)

While the India VIX has tended to trade in the 15 to 30 range in normal times, periods of high fear in the market have seen it shoot above 70. When selling climaxed in end-October 2008, the India VIX which was trading at 30-40 levels at the beginning of the month, shot up to over 80 to peak at 90. The VIX similarly shot up over 70 and hit 86 on March 25, 2020 the nadir of the recent bear market. The India VIX is currently at a sanguine 21, indicating a lack of panic in the markets.

Advances to declines

Whenever the Nifty dips, have you been scouting hard for bargain hunting opportunities? Well, as long as many investors are doing this, we are unlikely to get to a capitulation phase. 

Capitulation sets in when even the most bullish and long-term oriented investors after buying into successive dips, either get tired of further losses or run out of cash. At that point, they stop buying and simply decide to wait it out. 

The best way to gauge if a majority of investors have given up on the markets is to check the market’s advances-to-declines ratio. If a majority of listed stocks are awash in a sea of red submerging the few islands of green, that’s a sign of a bear market nearing its end-game. 

The NSE offers archival data on the advances-declines ratio both on a monthly and daily basis.

In the last week of October 2008, the capitulation phase of the GFC-induced bear market, the advances declines ratio on NSE fell to an abysmal 0.07. 1167 stocks on NSE fell that day, while just 81 managed to hold their head above water.  

In the second week of March 2020, when selling was climaxing, there were two trading sessions when the advances-declines ratio fell to 0.15. In recent trading sessions, the NSE advances-declines ratio has hovered at 0.3-0.4 levels. Watch for a dip below 0.20 to verify if we’re in the end-game.

Caveat

Of course, after making us all brace for the worst, it is also quite possible that the Indian markets don’t get into a capitulation phase at all for now, and simply keep moving sideways for months. 

When valuation bubbles burst, a time correction, where markets test investors by staying range-bound for a long spell and not breaking out in either direction, is as much of a possibility as a price-based correction. 

This is why it is best not to wait interminably in the hope of catching stocks at a capitulation phase. Deploy part of your cash whenever you find the stocks you want to own at attractive levels, while keeping some powder dry for that capitulation phase. This will ensure that you don’t lose out on buying opportunities, even if the mouth-watering opportunities provided by capitulation prove elusive.