Capitulation? What Capitulation?

The markets have been ruthless over the last few days. Anything and everything is being sold. The major indices are down around 30% from their all time highs, and are dropping further as I write this. The emerging markets are down around 60% on average. Everyone is looking for a buying opportunity. Is this the time where a value investor should feel like a kid in the candy store? Prem Watsa doesen't think so and he's putting his money where his mouth is (70% of his portfolio is in government bonds). He is expecting markets go to down at least 50% from their all time highs (this will put the S&P in the 750 range!) which is akin to the 1974 market declines. According to him there's a significant recession coming, long and deep. It's going to spread all across the world; It's very difficult to not be caught by it and it'll will be difficult for the Fed to do too much now as they are running out of ammo. As George Soros and Warren Buffett have said, this is the unwinding of the great credit bubble of the last two decades, and something that takes decades to build up is not dismantled in a few months; this will be a prolonged recession perhaps lasting many years.

So when will there be capitulation?

Prem Watsa further clarifies the definition: You'll know about it when no one here is optimistic. You'll know when there's no expectation of a turn. In September, there were resumptions, significant redemption; but history shows you've got to have months of resumptions. That's an indication that people are losing their confidence and want to be out of the market. You'll see the average pension fund going down to 30 per cent, 40 per cent equity allocation. ‘Stock' will be a bad word. This is akin to the 1980's when gold was at its highest and Barron's printed an article recommending gold and shunning stocks. Pension funds got the rules changed so that they could hoard more gold, and we all know what happened to gold and equities in the decades that followed.

Now just to be clear, there is a difference between the economic cycle and the stock market cycle. They lag/lead each other and seldom are in tandem. I do not expect the stock market to go down for years. What will likely happen now is that the analyst estimates will come down, and then the companies will show earnings; as long as the earnings are not beating estimates the market will keep going down. When however, the analysts are very very bearish (this is after the company goes bankrupt usually) and have very low expectations, this is when the stocks are really crushed and even the slightest earnings beat will provide substantial upside. This is the game wall street plays and knowing this a value investor can be careful and can adjust his buying and selling accordingly. So stocks are beaten down at the expectation that it will not beat expectation and then traded up or down with the actual expectations accordingly.

Update (21st November): Prem is buying. He essentially said that while the recession might be long and deep, the equity markets have discounted much of it.