The hidden story of investor capitulation

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.


The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.



My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.



The latest signals of each model are as follows:
  • Ultimate market timing model: Sell equities
  • Trend Model signal: Neutral
  • Trading model: Neutral

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.

Subscribers can access the latest signal in real time here.


Resilient retail sentiment?

AAII conducts two surveys, and they are different from each other. The weekly AAII survey asks respondents how they feel about the markets. The monthly survey asks them what they’re doing with their money. The latest monthly asset allocation survey shows that while equity weights have fallen, they are nowhere near the capitulation levels seen at the bottom of the 1990, 2003, and 2008 bear markets. It has led to the conclusion that retail investors haven’t thrown in the towel, which opens the door to further downside potential in stock prices.



A BoA survey of its private client equity allocations tells a similar story of falling weightings, but readings are nowhere near panic levels.


I beg to differ. The poor performance of the bond market in 2022 has masked the story of retail capitulation.



A 60/40 failure

The standard 60/40 portfolio consisting of 60% stocks and 40% bonds was an abysmal failure in 2022. Bond prices are supposed to provide a counterweight to stock prices. When one rises, the other falls. That’s the story of diversification. In the last three recessionary bear markets, stock and bond prices have moved inversely to each other. In 2022, they fell in concert with each other.



Had bonds risen as stocks fell in 2022, the pure price effects would have resulted in a lower equity allocation. It’s impossible to estimate the FOMO effect of investor psychology but had bond prices risen as stock prices fell, it’s likely investors would have shifted more funds from stocks to bonds and reduced equity allocations further. Using the BoA data as an illustration, I estimate the equity allocation based on price changes only to be about 57%, which would be slightly above the historical average.



The TD Ameritrade Investor Movement Index (IMX) is another survey that measures retail sentiment using actual fund flows rather than a sentiment survey. The latest reading shows that sentiment is depressed and just above the capitulation lows seen during the 2011 Greek Crisis and the 2020 COVID Crash. In short, retail sentiment is very depressed but not totally panicked just yet.



As well, data from Longview Economics shows the first significant instance of closure of Schwab accounts since the COVID Crash.



When we combine the retail sentiment readings with institutional sentiment surveys, this is what capitulation looks like.



In addition, Mark Hulbert highlighted possible upside potential in equity prices based on Robert Shiller’s U.S. Buy-on-Dips Confidence Index, which “is based on a monthly survey in which investors are asked to guess the market’s direction the day after a 3% market decline.
This past summer the index got lower than 7% of all other monthly readings since Shiller began this survey in the 1990s. While that in itself is low enough to impress contrarians, it’s also encouraging that the index hasn’t jumped more since then. The normal pattern is for bullishness to jump whenever the market begins to rally. But the index currently stands at just the 20th percentile of the historical distribution.


In fact, the latest reading is even lower than the one registered in March 2020, at the bottom of the waterfall decline that accompanied the initial lockdowns of the COVID-19 pandemic. But as for the summer of 2022, you have to go back to late 2018 and early 2019 to find another time when the Buy-on-Dips Confidence Index was lower than where it stands now. Those months coincided with the bottom of the 19%+ correction (bear market) caused by the Fed’s late 2018 rate-hike cycle.



Hulbert found that there was statistical significance in Shiller’s survey and documented its historical performance.



As an aside, several readers have asked me about the readings of the Trend Asset Allocation Model. I previously stated that the actual reading had been bearish, but I was reluctant to downgrade it because an allocation into the poorly performing bond market would not add any return to a portfolio in the current environment. I have re-evaluated the model and I can report that readings have improved to a bona fide actual neutral condition because of strength in non-US equities and commodity prices.



A new bear leg?

Despite the overwhelming evidence of sentiment support, the market may be starting a tactical bear leg. The NYSE McClellan Oscillator (NYMO) recycled from an overbought condition to neutral, which is a sell signal.



The 10 dma of the equity-only put/call ratio touched its 200 dma and bounced upwards, indicating that it is beginning to recycle from greed to fear.



However, I am not inclined to make a tactical sell call until price momentum has definitively turned. The 14-day RSI of the S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) is still overbought and hasn’t reverted to neutral yet, which has proven to be a very reliable sell signal in the past.



Commodity prices surged late in the week, and the cyclically sensitive copper/gold and base metals gold ratios also spiked on the expectations that China may relax its zero COVID policy and reopen its economy.



Ultimately, the bull and bear debate may have to be settled by the new small-cap leadership. The Russell 2000 has staged a relative breakout out of a broad base (bottom panel) while exhibiting a double bottom pattern (top panel). The key test will be whether the index can overcome falling trend line resistance, or weaken to test support one more time.



Traders should wait for further clarity before opening a position in this uncertain and volatile climate.



The week ahead

Two events next week are potential sources of additional market volatility. The first is the US midterm elections. Current polling indicates that the Republicans are likely to retake control of the House, but the Senate is too close to call. While markets may reflexively rally on the expectations that a divided government is bullish, equity investors may be better served if the Republicans control both the House and Senate as a divided Congress raises the disorderly tail risk of a debt default.


Republican House Leader Kevin McCarthy has vowed to spark a debt ceiling confrontation with the Biden Administration if McCarthy doesn’t get his priorities of rolling back social programs passed. Marketwatch reported that Republican Senators have gone as far as calling for social security cuts, which would be a political line in the sand that is sure to spark a fierce battle. The debt ceiling could be breached as soon as February. As a reminder, the market behaved badly during the last major debt ceiling impasse in 2011, though the Greek Crisis was occurring in Europe at about the same time. Nevertheless, the recent UK experience demonstrated that the markets don’t react well to fiscal uncertainty. If the Republicans were to control both the House and Senate, it would be much more difficult for them to deflect responsibility for a Treasury default, which makes a debt ceiling crisis less likely.



Investors will also have to recognize that the current version of the GOP is not as business-friendly as past versions. Axios reported that Kevin McCarthy is clashing with the leadership of the Chamber of Commerce, which is a highly unusual development in light of the historically friendly relationship between the Republicans and business interests.


House GOP Leader Kevin McCarthy is telling U.S. Chamber of Commerce board members and state leaders the organization must undertake a complete leadership change and replace current president and CEO Suzanne Clark, Axios has learned.
The next source of volatility is the closely watched CPI report on Thursday. The consensus expects headline CPI to rise by 0.7% and core CPI to rise by 0.5% sequentially.



The Cleveland Fed’s inflation nowcast calls for a headline CPI of 0.76% and core CPI of 0.54%, which are slightly ahead of expectations. Don’t be surprised if CPI comes in hot next week, which would be equity bearish.


In addition, the FIFA World Cup tournament begins the following week, on November 20. Mark Hulbert pointed out that equity markets tend to perform poorly during World Cup tournaments.
This research traces to a study two decades ago entitled “Sports Sentiment and Stock Returns,” conducted by finance professors Alex Edmans of the London Business School; Diego Garcia of the University of Colorado Boulder, and Oyvind Norli of the Norwegian School of Management. 


The professors analyzed stock market behavior following more than 1,100 soccer matches back to 1973. They found that, on average after a given country’s soccer team lost in the World Cup, its stock market the next day produced a return significantly below average. The professors did not find a correspondingly positive effect for the stock markets of countries whose teams won.


The logical consequence of this asymmetry is that the global stock market tends to be a below-average performer during the World Cup tournament. That is precisely what was confirmed by a follow-on study entitled “Exploitable Predictable Irrationality: The FIFA World Cup Effect on the U.S. Stock Market,” by Guy Kaplanski of the Bar-Ilan University in Israel and Haim Levy of the Hebrew University of Jerusalem.



In conclusion, my market analysis is a good news and bad news story. The good news is that retail sentiment is more washed out than generally believed. The combination of extremely bearish retail and institutional sentiment are likely to put a floor on stock prices should bearish catalysts appear. The bad news is the stock market faces a number of short-term challenges in November. Uncertainty over the midterm election and a possible fiscal fallout, a likely hot CPI report, and bearish World Cup seasonality will create headwinds for stock prices, especially when last week’s analysis showed that equity investors are positioned for a cyclical rebound (see What is the market anticipating ahead of the FOMC meeting?).


7 thoughts on “The hidden story of investor capitulation

  1. There are clearly two types of investors out there populating the various sentiment indicators, the conservative investors that are in the AAII and the aggressive REDDIT crew at TD and Schwab discount brokers. You can also see the two groups via the action of the DJII (AAII folks) and NASDAQ (discount brokerage traders).

    I read recently traders are down 44% this year which I think is a low estimate while conservative investors aren’t into the meme stocks and their losses are modest and not worrisome.

    So the graphs above show conservative investors haven’t capitulated since they aren’t down too much and they are raising cash holdings to buy in at a future. low. This is the one chart that will show real capitulation and a true market low at the bottom. These conservative folks aren’t seeing a recessionary economy and general bad earnings from blue chip companies that would scare them. They will when the recession hits.

    The aggressive traders and those ARKK-type believers who buy and hold the meme stocks with diamond hands are not parking in cash. They are fully involved and don’t have any buying power on the sidelines. Their stocks just swing from day to day with traders losing more and more money just like casinos do with gamblers. These are the folks closing their Swab accounts and the TD accounts, not the AAII geriatric crowd.

    Some would argue that the REDDIT traders have so little money to effect markets but with so much of outstanding stocks locked up in passive ETFs, their effect is high plus they tend to move in tandem. BTW they skew the options data wildly and don’t reflect the AAII investor there either. I treat those option sentiment indicators with suspicion especially since back years data didn’t have zero commission option trading.

    That leaves institutions as a group. Most of them have mandates that don’t allow them to get out of equities. They may say in a survey that they do or don’t like the market outlook but they are locked in. So with them we see shifts within the markets and now we see them reducing Growth and buying Value. On an quant basis, Growth is valued with long term bonds and that measure with bonds down so much this year means Growth needs to fall much more to get in line with theoretic levels. I don’t expect them to switch to Growth anytime soon especially since their private equity holding are very skewed to technology and other growth sectors. Private equity grew to a huge size with institutions.

    So I will wait for AAII capitulation.

    1. Note the cash spike in the AAII asset allocation survey. Readings are similar to the COVID Crash and 2011 Greek Crisis and US budget impasse highs.

      1. Yes, spike in cash during Covid Crash was panic but today it is also attractive yield. So I would expect much higher levels to indicate panic this time.

  2. Cam, it is likely that no candidate will win the GA Senate race on Nov 8th. The runoff election is on Dec 6th. The control of the senate won’t be decided until then.

    Will this also be bearish for the market even though the House control may be decided over the next couple of days?

  3. The 10 year is an anomaly…I looked at the weekly and SPX dating back to the 60s. In the late 60s there was a similar rise in 10yr yield with a falling SPX in 1969 and also 1973. Both times we got a market that fell into 1970 and 1974. Both times the 10 year yield dropped at the bottoms but the 1974 yield was higher than the 1970.
    After that the market went sideways to a little bit up even thought rates kept going higher. I look at it as nominal SPX going higher because of all the inflation of the late 60s and 70s. From 76 to 80 the market was flat, yet inflation was not. So in real terms the SPX was going down as treasury yields were rising going into 1981.
    If we get something similar then yields will stay up and we don’t revisit the zero level again. No idea how they swing this, but if we eventually get a market plunge and we see yields being cut, this is what happened in the 70s with a definite lag, but it was a sign the bottom was in.
    But if we are in for 10 years of rising yields the bond holders will feel pain because there is no way that holding to maturity will provide a decent return considering the yields of the last 10 years.
    One thing to watch is if yields over the next few years show higher highs and higher lows , as opposed to what has happened since 1981.

  4. Cam,

    It looks like the market began to move up when the USD began its move down late in the session.

    Do you have any view on USD? It has gained a lot this year. Time to go down? How much?

Comments are closed.