Capitulation in Commodity Markets
By Anil Mishra
What is the concept of capitulation?
In commodity markets, capitulation takes places when investors, stakeholders try to get out of the commodity market as quickly as possible. It’s also described as panic selling. It’s usually based on investor, stakeholder’s extreme fears that commodity prices will crash further than they have. Essentially, the selling stops when all the bears have been exhausted, sentiment completely craps out and there’s simply nothing left to do but buy. Capitulation doesn’t take place in the spot market but only on commodity derivative exchanges. Capitulation is usually signalled by a decline in the commodity markets at around 10% in one day. In Indian commodity market it can’t happen because Sebi regulation doesn’t allow drop of more than 4% in one day on the Indian commodity exchanges.
In getting out of the market, investors, stakeholders give up any previous gains in commodity price. That means they take a financial loss, just to get out of their commodity long positions. The reasoning behind this move is: take a smaller loss now rather than a bigger one later. Real capitulation involves extremely high volume and sharp declines in commodity prices.
Reasons for capitulation:
Capitulations are most frequently attributed to investors emotionally “giving up,” rather than to external forces like changes in the fundamental outlook of a commodity. This negative investor sentiment may be the cause (or effect) of reaction and opinion communicated by the media, analysts, traders, or other investors.
Imagine a situation when commodity price starts dropping and continues to drop. There are two choices for the investor or long position holders. He could stick to his position and hope that the commodity price would later appreciate—or they can take the loss by selling the commodity.
If the majority of investors, long holders decide to wait it out, then the commodity price will probably remain stable. But if the majority of investors decide to capitulate and give up on a stock, they start selling and that starts a sharp decline in a commodity’s price.
Does someone benefits from capitulation?
While weak holders and majority are caught in the grip of extreme fear and phobia, some buyers take benefit of this situation, they take contrarian views, and such buyers are ready to swoop in. After capitulation selling, common wisdom has it that there are great bargains to be had in the commodity market. Why? Because everyone, who wants to get out of his commodity stock or long position, has sold it. The price should then, theoretically, reverse or bounce off the lowest price of the commodity. These investors believe that capitulation is the sign of a bottom and a chance to get commodity stocks at a cheaper price than before the capitulation took place.
Can one predict capitulation?
Some people think that capitulation can be predicted which is not true. There is no way to predict the timing or price level for capitulation. Capitulation is the result of overreaction to any bad news or event. Capitulation is very difficult to forecast and it can’t be used as a way to buy or sell commodity. There is no magical price at which capitulation takes place. Certainly during the trading day, commodity prices and volumes are monitored and some measurement is used to determine if a capitulation is taking place and will remain so at the end of the day. But most often, investors and market watchers look back to determine when the markets actually capitulated and see how far commodity prices have fallen for that one day of trading.
When have there been capitulations in the world?
• As a result of capitulation in August 2015 commodities of all kinds were unusually weak causing August 2015 to be very bearish. Crude oil prices fell under $40 a barrel to a new, 61/2 year low. Copper prices slipped to a new, 6 year low. Soybean prices slumped to a 5 year low. The widely followed CRB Index fell to a new, 13 year low and below the most depressed levels of July 2015.
• The stock market crash of 1929, that helped lead to the Great Depression was a capitulation. In fact, it had more than one day of it. On Oct. 24, 1929—what’s known as Black Thursday—share prices on the New York Stock Exchange collapsed. A then-record number of 12.9 million shares were traded. But more was to follow. On Oct. 28, the first “Black Monday,” more investors decided to get out of the market, and the slide continued with a record loss in the Dow for the day of 38 points, or 13 percent. The next day, “Black Tuesday,” Oct. 29, 1929, about 16 million shares were traded, and the Dow lost an additional 30 points.
• There was a panic selling of stocks on Oct 2008, it can be considered a capitulation. Not only U.S. stocks, but global markets had major declines of 10 percent or more on one day. Investors flooded exchanges with sell orders, dragging all benchmarks sharply lower. It’s believed fears of a global recession and the U.S. housing slump sparked the sell-off.
If commodity capitulation has indeed taken place, expect a stiff rally into later years. Capitulation more simply explained means that when the last bull is forced to sell and the last bear adds to a short position, it is time for a market reversal and an abrupt change in psychology.