With every passing day, I get more questions about “market capitulation”. We have not reached that level yet, but at this pace it won’t take long.

Last week, the market dropped 5%. Right now, Europe and Asia are down 5% and the Dow futures have lost 500 points in Globex trading. Our markets are closed for holiday and there will be many shocked investors come tomorrow.

The first stage of our decline was caused by slowing profit growth and deteriorating economic conditions. This selling pressure caused the market methodically move lower. As the market has moved lower, the noose has tightened and investors are ready to bail.

Before you can reach a capitulation level, you have to see panic. That panic is created by uncertainty and investors need that overwhelming feel that the worst is yet to come.

The enormous write-downs taken by financial institutions have created anxiety and the lack of transparency has elevated the nervousness. We do not know how aggressively the assets have been marked down and the financial institutions themselves do not know if this lending crisis will spread to other mortgages.

There are a record number of hedge funds and most of them use leverage. When they are forced to liquidate to cover margins, a wave of selling creates a giant air pocket. We saw this last August when the “quant funds” were squeezed. They held a long/short portfolio and when the longs fell faster than the shorts, they were forced to liquidate to meet margin calls.

There are other strategies like the “Yen Carry Trade”. Hedge funds have shorted the yen to finance high flying commodities. We don’t know the risk exposure for this trade and again, uncertainty exists. As commodities fall, the funds will be forced to liquidate positions.

So far, we have not seen a panic sell off. There have been some nasty days, but nothing that gives you that gut wrenching feeling that everything is coming apart at the seams. That type of move is usually caused by a huge (50 S&P 500 points) drop. If the market fails to snap back, the low has not been reached. During these moments, stocks that you love will drop more than you ever could have imagined. Remember, liquidations are forced at this stage and good stocks are being sold with the bad. In fact, you know you are reaching support when the market leaders are tanking. It is at that stage that traders and investors have to sell their best positions to meet margin calls. If they don’t, the brokerage firm will do it for them.

As you can see in the chart, I have outlined a number of capitulation levels that we saw after the “tech bubble”. Notice that the best capitulation did not occur until the market was 20% off of its high. I am not equating our current market condition to the year 2000; I am simply stating that we are just getting to the stage where we can expect capitulation.

Another sign of capitulation is a spike in the VIX. That index measures the implied volatility of options on the S&P 500. In short, it represents the cost of portfolio insurance. The greater the uncertainty, the more investors are willing to pay for insurance. When the VIX spikes, the market often finds support. The VIX has been climbing higher and tomorrow it is likely to explode.

We need to see a huge drop and an intraday snap back rally. The market needs to erase all of the losses for the day. The next day, the market needs to follow through. This type of price action indicates that buyers are willing to scoop up value.

I believe that this market has issues that will need to be worked off. Any snap back rally will eventually fail and that will present another shorting opportunity. This market will not snap back and you should not expect a “V Bottom” like we saw in March and August last year. I am not bullish long-term, however, I do see some very good values in the market.

If you look at the chart, you will see that the capitulation lows represented great opportunities to get long if you did not overstay your welcome.

Tomorrow’s drop might find support or it might not. Do not initiate longs until the reversal is in and the market closes way off of its low. Don’t add to you longs until there is follow through.

This market condition is an excellent opportunity for covered call writing. Consequently, I have reduced the price of my online video course, “Covered Call Writing – The Right Way!” by 25% for a limited time. Subscribe now for just $149.99.

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