In investments, there is an old saying: “Even a dead cat will bounce if it is dropped from high enough.” It is a popular phrase in the world of investments and is often difficult for analysts and traders to predict. From this comes a temporary recovery in the price of a declining stock. This trading pattern takes its name from that saying, which is the ‘dead cat bounce.’ Generally speaking, this pattern is indicative of continuing weakness within the market.
This article will dive further into what this ‘bounce’ is and will explain why it’s so important.
What is it?
A ‘dead cat bounce’ is a form of momentary recovery from a lengthy decline. Alternatively, from a bear market that precedes the continuation of the downtrend. For context, a downtrend refers to the price action of a security. One that is moving lower at a price as it fluctuates over a period of time. A dead cat bounce is a small recovery with a short lifespan in the price of diminishing security. An example of such security is a stock. Downtrends experience frequent interruptions by brief periods of recovery, or small rallies. This is typically where prices will temporarily rise.
Stock analysts use this pattern as a means to determine what a surge in a stock’s price following a major correction is. Is it a reversal of the downward trend or is it nothing more than a dead cat bounce? These bounces are usually observed in hindsight. This is largely due to how difficult it is to figure them out from a simple trend reversal. Most of the time, the cause of a spurt can be because traders and investors bargain buying. They will sometimes mistake the bottom of the stock price.
What does it tell you?
A dead cat bounce is a price pattern that technical analysts frequently use. They focus primarily on patterns of price movements, trading signals, and various other analytical charting tools. Doing so allows them to grade and classify both the strength and the weakness of a security system. They closely analyze investments drawing from previous market prices and technical indicators. According to their close and careful interpretations of past trading patterns, these analysts attempt to perceive the balance. Their intent is to predict any future price movements.
It is considered a continuation pattern. These patterns suggest that the price will keep moving in the same direction following the completion of a continuation pattern. They tend to be reliable when the trend moving into the pattern is considerably strong. Moreover, when the continuation pattern is small in comparison to the trending waves.
The dead cat bounce may initially appear to be a reversal of the prevailing trend. Later, a continuation of the downward price move follows it. It officially becomes a dead cat bounce – not a reversal – after price plummets below its prior low. Short-term traders will often try to profit from the small rally. Likewise, traders and investors may attempt to utilize temporary reversal as an opportunity to commence a short position.
Time and again, downtrends experience brief periods of recovery when prices momentarily rise. This is often the outcome of traders or investors closing out short positions. Alternatively, when they buy on the assumption that the security reaches a bottom.
As you may recall, a dead cat bounce is a price pattern whose recognition is primarily in hindsight. Analysts typically try to forecast that the recovery will be only temporary by utilizing specific technical and fundamental analysis tools. A dead cat bounce can be seen in one of two ways. Either in the broader economy – like during a recession – or in the price of a stock or group of stocks.
Recognizing a dead cat bounce ahead of time shares an important similarity with identifying a market peak or trough. That being the process is full of difficulty, even for investors with more skills and experience.
A notable example would be in March of 2009 pertaining to Nouriel Roubini of New York University. He refers to the incipient stock market recovery as a dead cat bounce. Furthermore, he would predict that the market would reverse course in short order and inevitably plummet to new lows. As a matter of fact, March of 2009 would indicate the beginning of an extensive bull market. It would eventually go on to surpass its pre-recession high.
With all of this in mind, it is important to note that a dead cat bounce is not necessarily a bad thing. In the end, it all depends on your perspective. For instance, you will hear very few complaints from day traders. These people look at the market from minute to minute and adore unpredictability. Taking their investment style into account, this bounce has the capability of being a tremendous money-making opportunity for these traders. However, this style of trading requires an enormous amount of dedication. Not to mention skill in reacting to short-term movements and substantial risk tolerance.
On the other end of the spectrum, you’ve got long-term investors. These people are likely to get upset when they endure more losses. This is especially the case when it is immediately after they thought that the worst was out of the way. If you are a long-term, buy-and-hold investor, there are two principles that you should follow:
- A diverse portfolio can provide sizable protection against the severity of losses in any one asset class. Let’s assume that you assign a portion of your portfolio to bonds. In this particular case, you ensure that some of the assets you invest in are working independently from the stock market movements. This basically means that your portfolio’s worth will not erratically fluctuate with short-term ups and downs.
- A long-term time horizon will likely calm the nerves of those investing in stocks. This consequently makes the short-term bouncing cats a lot less of a factor. For instance, you may notice that your stock portfolio is losing 30% in a single year. However, take comfort in knowing that throughout the 20th century, the stock market was yielding an annual average between 8-9%.
At the risk of sounding repetitive, identifying a dead cat bounce is mostly done after the fact. This essentially means that traders noticing a bounce following a steep decline likely believe it is a dead cat bounce. Contrary to this belief, it is a trend reversal. That is to say, rather than being a brief bounce, the rally will probably signal an extensive upswing.
There is a noteworthy question that stems from this. How exactly can investors determine if a current upward movement is a dead cat bounce or a market reversal? Answering this inquiry correctly is not simple. If we had that luxury, then we would be able to make a considerable amount of money. The truth of the matter is there is no simple answer when it comes to properly spot a market bottom.
Downward markets are not typically ideal. When the market manipulates you by teasing brief gains after huge losses, you find yourself being pushed to the limit. For traders, the key is to determine the difference between a dead cat bounce and a bottom. For long-term investors, though, the key is to diversify your portfolio and think of the long run. It is quite unfortunate that there are no easy answers available. Still though, knowing what a dead cat bounce is and its effects on different market participants is better than nothing.
If you want to learn more about charting and tools for charting, read “Best tools for Crypto Charting.” You will also learn more about tools pertaining to technical analysis. Furthermore, to find out if you are a technical trader, read “Are you a Technical Trader?”