How to tackle a ‘panic bottom’

Panic bottoms, which are sharp price drops accompanied by large volumes, frequently occur in stock price and index chart patterns. It is important, therefore, that investors understand and learn how to tackle a panic bottom in a portfolio stock.

This is a follow up to last Friday’s post about the Crompton Greaves price crash after the Q1 results fiasco, which raised quite a few comments and queries from blog readers and investment group members.

The nature of some of the queries and comments mentioned below motivated me to write this post:

‘I bought at a higher price. What should I do now?’

‘I bought on the day the stock crashed, and will buy more if it falls further.’

‘A big fund bought large quantities on the day of the fall. Shouldn’t we buy as well?’

Like promises, technical analysis rules are made to be broken. That doesn’t mean we shouldn’t be aware of the rules before playing the game. So, here are the two basic rules about panic bottoms:

1. Panic bottoms usually occur in the middle (or second) stage of a bear market

2. Panic bottoms seldom hold.

How do we know if a stock is in a bear market? In a post titled: ‘Is this a Bear Market, or a Bull Market correction?’, I had provided four different definitions of a bear market. Let us look at the chart pattern of Crompton Greaves to find out if it was in a bear market when the ‘panic bottom’ occured:

In Jan ‘11, two of the definitions were satisfied: the stock corrected 20% from the Dec ‘10 peak of 349, and fell below the 200 day EMA. In Feb ‘11, the dreaded ‘death cross’ (marked by light blue oval) of the 50 day EMA below the 200 day EMA confirmed the bear market. (The fourth definition – a >50% correction of the previous bull rally – wasn’t checked, since three of the four definitions were met.)

The rally that led to the Apr ‘11 top above the 200 day EMA was a good opportunity to exit the stock. In the next (second) stage of the down move, the ‘panic bottom’ occurred – accompanied by heavy volumes.

An upward bounce from the ‘panic bottom’ – caused by bottom fishing and short covering – was a selling opportunity. Today’s low and close were both lower than the ‘panic bottom’ low of 171. Both rules of the ‘panic bottom’ have been followed.

The lessons?

1) Once a bear market is confirmed, hanging on to a stock – regardless of its fundamentals (or lack of them) – doesn’t make any sense. Use the first bear market rally to exit, and avoid the gut-wrenching experience of a ‘panic bottom’.

2) Don’t try to bottom-fish on a ‘panic bottom’ – because lower prices will be available later. It is safer and prudent to wait for a clear signal of change of trend before entering.

The curious case of Crompton Greaves

This is not a post about a court-room thriller, even though the title may sound like one of Erle Stanley Gardner’s page turners. That doesn’t mean that the process of discovery of the real cause behind the serious hammering of the stock price of Crompton Greaves may not be an exciting one.

First, the facts. A less than stellar Q1 result due to significant reduction in the consumer business (mainly electrical appliances) was a shock. That was followed by the revelation that the erstwhile CEO had dumped his entire stock holdings of 180000 shares earlier in the month.

The former CEO took pains to explain that:

(a) he doesn’t like to invest in the stock market but had received the shares as part of his compensation some 11 years back; at that time he had resolved to sell the shares immediately after retirement

(b) he retired on June 1, 2011 and sold the shares within a month of retirement after following due process of informing SEBI and the stock exchanges.

Doubts remained in the minds of investors because of three reasons:

1. Insider selling of large quantity of shares is considered a warning sign

2. Though he retired on June 1, 2011 Mr Trehan is still associated with the company though he doesn’t draw a salary. That means, he had insider’s knowledge about the poor Q1 performance of the company

3. The timing of the sale seemed a bit fortuitous. What if the stock market was in a deeper correction? Would he have sold his shares at lower prices? Alternatively, if the market was in the midst of a strong bull run, would he have waited a little longer to sell at a higher price?

Only Mr Trehan can answer those questions. Bottom line is that a lot of small investors were shaken by the severity of the stock price crash. Since such a crash didn’t occur when the ex-CEO actually sold his shares three weeks back, fingers are being pointed towards a bear cartel that used the fact of the insider sale as an excuse to hammer down the stock price. A fit case for SEBI to look into.

The Joint Managing Director of Havell’s – a competitor of Crompton in the consumer appliances space – does not believe that there is any cause of worry. Retail prices were hiked some time back due to increase in input costs. That may have led to consumers delaying their buying decisions. Another explanation is that distributors picked up more inventory in Q4 to avail of the then lower prices. That is why they lifted less inventory in Q1.

What should small investors do? On a TTM EPS of 10.61, the P/E at today’s closing price of 182.55 is 17.2. Not mouth-watering valuation by any means, but not hugely expensive either. If you are planning to enter, you may want to wait for Q2 results and then decide.

If you are holding the stock and are in profits, use the short-covering bounce up to book a part of it, and hold on to the rest. Remember the old stock market adage: When in doubt, stay out.