What is market capitulation?
You may have started to hear or may shortly hear the term ‘market capitulation’ after the end of this week’s share market falls around the world. But what is ‘market capitulation’?
By definition, capitulation means to surrender or give up. In financial terms, this term is used to indicate the point in time when investors have decided to give up on trying to recapture lost gains as a result of falling stock prices.
For example: Suppose an investment you own has dropped by 20%. There are essentially two options that you can take:
- you can wait it out and hope the investment begins to appreciate, or
- you can realise the loss by selling the investment.
If the majority of investors decide to wait it out, then the price of that investment will likely remain relatively stable. However, if the majority of investors decide to ‘capitulate’ and give up on the stock, then there will be a sharp decline in its price. When this occurrence is significant across the entire market, which is what we have been seeing in the past week, it is known as ‘market capitulation’.
The significance of capitulation lies in its implications. Many investment professionals consider it to be a sign of a bottom in prices and consequently a good time to buy investments. This is because basic economic factors dictate that large sell volumes will drive prices down, while large buy volumes will drive prices up. Since almost everyone who wanted (or felt forced) to sell stock has already done so, only buyers are left – and they are expected to drive the prices up.
The problem with capitulation is that it is very difficult to forecast and identify. There is no magical price or level at which capitulation takes place, and so we can generally only see in hindsight as to when the market actually capitulated.
Tags: education, investment, Investment strategy