Capitulation Precedes Dow Theory Buy Signals

Total capitulation only occurs at or near the end of bear markets and it occurred on Thursday, September 20th, the day before THE low of the bear market. It doesn't always happen during each bear market's death throes, in fact since 1960 capitulation has happened at seven of the eleven bear market's conclusions but did not happen at all on the other four. But when capitulation happens it identifies and ends bear markets.

What is capitulation? Capitulation as it relates to the stock market is when investors, speculators, whomever 'throw in the towel' because they are so disheartened, fearful, need to meet margin calls, or whatever. It is often called a 'selling climax' as stocks cascade down into a cataclysmic sell-off. The word 'capitulation' is not uttered in writings about the Dow Theory, but it was clearly alluded to in the early 20th century. The third phase of a bear market was described in "The Dow Theory" by Robert Rhea in 1932 as "caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets. After a market has drastically declined, and then goes into a semi-panic collapse, it is wise to cover short positions and even perhaps make commitments for long account".

Turning the generality of capitulation into a specific identification has been tried by a number of methods, but very few have consistently identified them as they occurred. In fact, it CAN be measured and identified quite specifically. From a database starting in 1953 there have been seven total capitulations. They were on 6/22/62, 5/25/70, 8/23/74, 10/19/87, 8/23/90, 8/31/98 and recently on 9/20/01. They were within 0.5%, 1.6%, 18.9%, 0.0%, 5.0%, 0.0% and 1.7% of the lows, respectively, for an average of within 4% of the lows. Only once was the bottom over 5% lower, and that was during the 1974 Arab Oil Embargo.

The calculations that determine these capitulations are rather complex and are proprietary. Suffice it to say, however, that they utilize a Short-term Oscillator, which measures the percent of divergence between the three major stock market indices (Dow Jones Industrial Average, Standard & Poor's 500 and the New York Stock Exchange Composite) and their ten-week, time-weighted moving averages. They can be calculated during a trading day but are determined by closing prices. For instance, the markets were in total capitulation during the day on 3/21/01 while the Dow Jones was between 9,100 and 9,300, but not on a closing basis. Yes, the market then bounced to over 11,300 in 8 weeks but the record of such partial capitulations is not sufficiently dependable to warrant acting on it every time. Other partial capitulations have been followed by further declines of over 22% on three different occasions, hardly a confidence builder. But total capitulation on a closing basis is a unique happening, certainly valuable information to know about and act upon.

Comparing the dates shown above for capitulation with the dates that my interpretation of the Dow Theory gave Buy signals shows a direct correlation. Buy signals have followed from two weeks to five months (3 months on average) after total capitulation on all six previous occasions, and bull markets were already underway for five of the six Dow Theory Buys (one started a month later).

As to the current status of the Dow theory, the first bounce up from the lows appears completed with a 14.3% bounce on the Dow Jones Industrials and a 13.8% bounce for the Transports, which took three weeks (a day short on the Industrials, but close enough). Now there must be a pullback exceeding 3% on either of those averages and that looks to be happening now. When this testing phase is completed above the September lows, a Buy signal will be flashed if and when the recent highs of 9419.45 on the Industrials AND 2314.80 on the Transports are surpassed. Because major-trend market timing, as espoused in the Schannep Timing Indicator and TheDowTheory.com Newsletter , is concerned with the major markets of the New York Stock Exchange and Standard & Poors 500, the most appropriate investment vehicles are either Index mutual funds that track the S&P 500 or the Dow Jones Industrial Averages, or "Spiders" and/or "Diamonds". Spiders (ASE: SPY) derive their name from "Standard & Poor's Depositary Receipts" and are exchange-traded securities created to track the performance of the S&P 500 Composite Stock Price Index. They trade like stocks and the dividends are distributed quarterly equivalent to the dividends paid by the underlying stocks in the unit investment trust, less annual fees of about 0.18%. Diamonds (ASE: DIA) are similar but track the Dow Jones Industrial Average. While a commission must be paid to buy or sell either stock, the advantage over Index mutual funds is that they can be bought or sold during and after the normal trading day, not just at the closing price as mutual funds are. This advantage cannot be emphasized enough, as is found when a Buy or Sell Signal is communicated during a trading day. To be able to get the current price (near the net asset value) rather than what it might happen to be at the end of the day could be a significant difference. Also the advantage of being able to trade after market hours can be important. Margin trading through the securities is available, and they can be sold short without the need for an 'uptick' in price. In a word, they are as close to the ideal vehicle for utilizing market timing as exists. Of course they go up and down, and money can be lost if they are sold at a lower level than purchased. A Prospectus is available on each and will clarify the above or any other questions that you may have: ASE, 86 Trinity Place, New York NY 10006.