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.