What is market capitulation?

Market capitulation is a term used by investors and traders during times of market decline. It refers to an extreme point of panic selling, where investors are willing to sell their assets at any price, resulting in a rapid decline in prices. Dictionaries define capitulation as the act of surrendering, which is a good way of thinking about how capitulation works in financial markets.

So what causes capitulation to occur, and what are some warning signs? Although predicting when capitulation will occur and for how long is challenging, here’s what you should understand about market capitulation.

What is market capitulation, and how does it work?

Market capitulation happens when investors and traders reach a point where they can no longer tolerate falling prices and sell their assets out of fear and panic. This happens in any asset class, like stocks, bonds, commodities, and is triggered by negative market conditions.

When a market selloff begins, there are often investors who come in and “buy the dip,” thinking a market will quickly rebound or that they’re getting a bargain-priced asset. However, if the market downturn continues,  traders may become increasingly short-term focused and concerned that prices will continue to fall. When traders reach this point of maximum pessimism and just want their losses to stop mounting, they sell their assets and capitulate.

Signs of market capitulation

It can be challenging to recognize market capitulation in the moment, and it’s often easier to identify it in hindsight. However, there are some signs to look for that might indicate a market has reached capitulation. These include:

• Volatility – An increase in volatility is often seen during market capitulation. This may include a sharp downward move in prices that may be followed by a recovery. The VIX, an index which tracks volatility, will likely spike at this time.
• Spike in volume – Volume also may increase significantly, as sellers exit their positions in the hope of getting out before things get even worse.
• Put-call ratio – An increase in the equity put-call ratio may also occur, as traders try to position themselves for continued selling pressure.
• Increased cash balances – Cash balances may rise as investors and traders get out of the market and move to the sidelines until the outlook improves.

Is market capitulation the same as a market bottom?

Market capitulation is not the same as a market bottom, though the two may occur at the same time. Capitulation refers to the point when investors and traders can no longer tolerate falling prices and sell their assets out of fear. A market bottom is the point where prices stop declining and begin to recover. While capitulation is typically followed by a rally of some sort, it doesn’t necessarily mean that the market has bottomed out.

In the fall of 2008, as the financial crisis was wreaking havoc on the financial system, markets were extremely volatile as rumors of bailouts and rescue packages came and went. The S&P 500 Index fell about 30 percent in a matter of weeks, before stabilizing. At the time, many investors thought the market bottom had been reached, but stocks continued falling over the winter as the economy worsened. The market finally bottomed out in March 2009, down nearly 60 percent from its high reached in October 2007.

Bottom line

While traders and professional investors may talk about market capitulation, long-term investors should stay focused on the long term and not try to jump in and out of the market. Capitulation and market bottoms are very difficult to identify and are typically best seen in hindsight. Those who participate in market capitulation by selling investments when prices are down are usually doing so at one of the worst possible times. Staying focused on your long-term goals should help you ride out the inevitable market downturns and periods of high volatility.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.