I keep hearing and reading that the market will not bottom until there is maximum fear and capitulation selling.  This is a commonly held view by many investors.  But is it true?

No it is not necessarily.  Bottoms can be marked by capitulation selling but bottoms are as likely, if not more so, to be marked by selling exhaustion.

The VIX is one measurement of fear.  Generally, the higher the VIX, the higher the fear.  Ergo, the VIX should be highest at the maximum point of fear, which should mark the capitulation bottom.

Let us see what happened during the last bottom, which occurred in 2002 and 2003.

The blue line is the S&P 500, with the scale on the left.  The red line is the VIX, with the scale on the right.

The bottoming process in 2002 and 2003 occurred over several months.  The first bottom was in August 2002, marked by the letter "A" below the blue line.  The VIX was at the highs at the point, indicated by the later "A" above the red line.  At the second bottom in October, marked by the letter "B," the VIX jumped but did not reach the levels in August.  At the final bottom in 2003 at point "C," not only was the VIX at a lower high than the previous tops in 2002, it was trending down as the market was falling.

So, in fact, fear - as indicated by the VIX - was falling as the market re-tested the lows. 

Also, the biggest volumes and sharpest drops occurred at the first low, as you can see here.

The rate of decline in October 2002 was less than the decline in August 2002, and the selling volume was lower.  Similarly, the rate of decline during the last bottom in 2003 was less than October 2002, and volume at the 2003 bottom was less than the October 2002 low.   This is evidence of selling exhaustion rather than capitulation selling.

In his excellent book Anatomy of the Bear (which I will get around to reviewing), Russell Napier makes the same observation.  Napier concluded that at the end of bear markets in 1921, 1932, 1949 and 1982, bottoms were marked by exhaustion selling, not capitulation selling.

However, this does not mean that bottoms are never marked by capitulation selling, nor that the ultimate bottom in this bear market will not be marked by capitulation selling.  Rather, waiting for capitulation selling may mean that you will miss the bottom when it occurs as the bottom is not always marked by capitulation selling.

In fact, this pattern may be occurring now.

The VIX may be making lower highs as it did in 2002-03.

Also following the pattern of 2002-03, the rates of decline have been less during successive lows, while volume on the lows have been below the October low.

Of course, history does not always repeat itself.   And unlike 2002-03, we keep hitting lower lows, and thus cannot conclude that the bear market is at an end quite yet. 

However, we must be aware that what is accepted as conventional wisdom on Wall Street is not always correct.