Summer of Capitulation

When I was a new bond trader working for the capital markets division of First Interstate Bank, Charlie, a wizened old trader assigned to be my mentor, told me repeatedly: "Remember, you make your money when blood is running in the street." I was sitting next to him on Black Monday, October 19, 1987. He smiled and chain-smoked his way through the day. In the midst of the carnage he went to work setting his bond positions. He made a ton of money.

That image of Charlie calmly smoking his way through what seemed to me to be the end of the world has stayed with me for over twenty years. I have found it to be very reassuring as I have tried to guide clients and investors through every major financial debacle since then. Some have been willing to ride out the storms; some have not. But I can honestly say that those who patiently stayed the course have come out alright.

We call it a "capitulation" when the market melts down and there seem to be no buyers left on the planet. They are periods of raw fear. They are unreasoning and unrelenting and they can try even the hardiest of souls. Yet they can also produce some of the most compelling buying opportunities. Sometimes capitulations happen like Black Monday, cascading in ever increasing volume over a very short period of time. Such capitulations are dramatic and very rare. More typically, capitulations happen over a period of weeks or months, gradually wearing down investor resolve and picking up momentum as they roll along.

We are in the latter type of capitulation right now. Between rising oil prices and the ongoing credit crisis, there is plenty for investors to worry about. I cringe every time I pull into a gas station or stop by the grocery store. Yet stocks are cheap! If you take company-by-company earnings projections for every stock in the S&P 500 for the next 12 months and compare them to the current level of the S&P 500 (which closed just below 1,300 today), the stock market is close to its cheapest levels of the last 20 years. In fact, you would have to cut the latest earnings projections by another 30% before you would get the P/E ratio back to the average level of the past 20 years!

At times like this I like to ask myself what Charlie would do. I'm sure he would be buying.