Was Friday A Capitulation?
A: In my opinion, no. This is the trader in me talking here. I do keep an active trading account open, and if you want some disclosure, I have been trading the ultra short ETF's (SKF, SRS, EEV, FXP, SDS, DXD, DUG, etc..) since Sept-Oct (1, 2, 3, 4 discussions on this) of last year; when the credit markets really started to deteriorate before the equity markets followed. Friday's selloff was a 2x4 hitting equity investors in the face, waking them up to reality (so to speak) that macro forces don't go away so easily! But I did not get the sense of fear that would characterize a capitulation day. While it certainly felt painful to many, give us a day where the equity markets hit an intraday low of down 5-6%, and then we could talk about a flush-out of the system. For me, Friday's selloff was a stepping stone of fear.
Take a look at the VIX (which is an index of short term volatility and widely used as a measure of investors' fear level - the higher the VIX, the higher the fear; for traders, you sell your long positions when fear is low, and buy into new long positions when fear is very high after the selloff), and you will notice that it jumped 26% on Friday's selloff:
In the past 6 months, the VIX hit this level on the upside 5 times (shown on the above chart), excluding Friday's move. When I look back at the week FOLLOWING the vix reaching the current level, the S&P:
#1 (DEC 11th - 18th) - 1,477 to 1,445 or DOWN 2%
#2 (JAN 4th - 11th) - 1,411 to 1,401 or DOWN 0.7% (with a 5.1% drop 3 weeks following)
#3 (JAN 16th - 23rd) - 1,373 to 1,338 or DOWN 2.5% (S&P surged 25 pts on the last day)
#4 (FEB 28th - MAR 6th) - 1,367 to 1,304 or DOWN 4.6% (hitting 1,273 4 days later)
#5 (APR 14th - 21st) - 1,328 to 1,388 or UP 4.5% (only time in the past 6 months that S&P rose the week following a rise in VIX to the level reached on Friday)
#6 (JUN 6th - 13th) - ??????????
I only went back 6 months for this out of my own curiousity and because I wanted to see the reaction in the equity markets to the VIX in this current credit crisis cycle. Interesting nonetheless.
This tells me that investors' fear level jumped Friday, but it's not the capitulation that may mark a tradable bottom (like the intraday low hit in January when SocGen news broke, or the closing low in early March before the BSC news hit). Both those events had several days leading up to the low hit. Friday's selloff seemed more to me like a stepping stone in fear, waking us up to the multiple whammies of a credit crisis, housing recession, oil surge, weak jobs report, and weakening economy. It was like someone said, "...ummm, what the hell just happened", instead of saying, "....holy s#@t....the market's are getting destroyed!!".
As stupid as this sounds to non-traders, we must have the destruction in order to ultimately get through this in terms of pricing risk into equities. Since the stock market as a discount mechanism is the preferred gauge of the economy for so many people, and a measure of paper worth for so many people, this topic is important to discuss. For those interested in how I treat days like this, I sell out of some of my ultra short positions, limiting my short exposure and taking some profits yet still holding 40-50% of the original total position. Since August, I have been focusing my trading strategies on timing the short plays; getting long (which means short) on the rallies, and lightening up (which means exiting the shorts) on the selloffs; I don't always hit the tops & bottoms, but for me, I fine tuned my strategy after years of trading and following the equity markets. I am not long any positions and usually hold any one trade for 1-2 months, from opening the position to closing it; a far cry from the minute-to-minute trader I used to be from 1998-2004 with Tradescape (now Lightspeed Trading, LLC)
With the VIX surging on Friday and the perfect storm of macro forces at play, we are at a new step of fear. As the VIX climbs, the destruction day gets closer. Even if an event can be avoided, an escalation of fear could cause a crisis of confidence that in and of itself causes the event leading to the capitulation. That's how this cycle usually works. Expect volatility to be high as long as the VIX is above 23-24, and be especially cautious if it rises above 30.