When Markets Panic: Capitulate or Ride It Out?

(eToro Blog) Give up, throw in the towel or call it a day, whatever words you use to describe capitulation it all means the same thing – to surrender. Capitulation has many applications, including among Wall Street’s traders. In simplest terms, it’s akin to a fire sale, i.e. getting out of the market as quickly as you can with (hopefully) the shirt still on your back.

Why capitulate? It happens when you, or any investor, believe that stock prices are on the edge of a precipice with no where to go but down. Capitulation is steeped in fact not just belief; data shows that fire sales or panic selling has typically been preceded by a 10% decline in a single day.

A trader in a panic may give back any earlier gains and wind up with a financial loss in the process. The rationale behind capitulation is this: you should take your losses now and avoid a larger one down the road. If too many investors accept that rationale, that begins the downward spiral that could be difficult to curtail. Some investors believe that capitulation indicates a bottom, though that has been proven wrong time and again.

Declines in individual stocks have also been known to hit a point of capitulation; last Friday, Apple prices took a bit of a dive (not near 10% but enough for Apple with a 3.6% loss) and some analysts expected to see further capitulation on Monday. What happened is that Friday’s drop was sufficient enough to bring in some bargain hunters.

The thing about capitulation is that you can’t predict it, though monitoring of volumes and prices can help to determine if it is occurring, but in the end only 20-20 hindsight will confirm whether or not capitulation occurred.

But with capitulation is compromise; traders don’t move out of the markets wholesale, they venture back in albeit a little (sometimes a lot) more carefully and look instead for less risky choices. And who benefits from capitulation? Of course, it’s the buy-low sell-high contingent, ready to swoop in and grab a bargain. And there are bargains galore in a market capitulation, since anyone who previously owned shares has since dumped them; in theory the price should start back on an upward path.

Back in October 2008, at the peak of the U.S. financial crisis, there was panic selling on banking shares. At the same time, mega investor Warren Buffett was scooping up shares of Goldman Sachs at a bargain price, and his buy and hold philosophy kept him in good stead until he agreed to sell back Goldman Sachs’ $5 billion in preferred stock last year (at a very tidy profit, of course).

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