Was it a panic bottom or a capitulation?

Within a matter of a few minutes after opening of trade, the Sensex fell sharply by more than 500 points on Mon. Jun 20 ‘11. The Nifty dropped nearly 200 points. What happened?

Apparently, the selling was triggered off by the news that the Indian government was planning to review the double tax avoidance treaty with Mauritius. The treaty stipulates that taxes on capital gains incurred in India on sale of stocks by Mauritius entities will be payable only in Mauritius (which does not levy any capital gains tax).

It is unlikely that Mauritius will agree, since the tourism paradise has little industry of its own. They attract investors with the lure of their liberal tax regime. Many companies have set up shop in the island nation primarily to invest in the Indian stock markets.

40% of the so-called FII inflows into the Indian markets come from Mauritius. It is an open secret that much of this money is ‘round-tripping’. In other words, black money is sent to Mauritius through ‘hawala’ channels from India. That money comes back into India under the garb of FII inflow, and black money turns into tax-free white money.

It is laudable that the Indian government is trying to plug a loophole through which crores of capital gains tax are slipping through. But it is unlikely to happen any time soon – if at all. Then why the panic?

It was just a ‘negative’ news that seemed to get discounted in haste. Such sharp falls are typical in bear markets. The market has been in a down trend for seven months, without falling even 20% from its Nov ‘10 top (which is one of the definitions of a bear market). Bears tried to force the issue in their favour by using the treaty review news as an excuse to start selling.

Stop-losses got triggered as the indices dropped through known support levels, and added to the panic. Two thing happen in such situations. Weak holders tend to capitulate. Bottom-fishers start buying and lend some stability to the market.

So, was it a capitulation or a panic bottom? We won’t really know till Mr Market tells us in which direction it wants to go. A capitulation usually happens near the end of a bear phase, when investors get weary of waiting for things to improve, and start selling off at any price. It tends to be a slow, grinding down process followed by the start of a new bull phase.

A panic bottom, on the other hand, sets up a temporary bottom before the next down move, because panic bottoms seldom hold. This is another one of those ‘technical rules’ which don’t always work. The interesting point to note is that the Feb ‘11 lows of the Sensex and Nifty were tested but not broken. That keeps the door open for a double-bottom reversal. Possible, but seems unlikely at this stage.

What should small investors do? Maintain a strict stop-loss at the level of the Feb ‘11 lows. If those lows are taken out, another 10-15% correction from current levels will not be surprising.