Dead Cat Bounce: Short-Term Relief on Financial Markets

Dead Cat Bounce: Short-Term Relief on Financial Markets

When markets are in a downward trend, as they are now, everyone searches for the bear market bottom; this is the key moment when investors become more confident in the future. On the path to this long-awaited moment, there are several setbacks, and the dead cat bounce is a slang term for these ephemeral rallies.

A stock is said to have performed a dead cat bounce when it was trading in a downward trend but then staged a brief rebound before continuing to fall – It is a regular occurrence for investors to become hopeful after reading positive news about a company and to assume that the company is on the verge of turning a corner, only to be let down when the company does not.

What is a Dead Cat Bounce?

A temporary increase in the price of a falling asset or stock is referred to as a “dead cat bounce” in the financial markets. This phrase was coined to describe the phenomenon – The name derives from the misconception that if a dead cat is dropped from a great height, it will bounce back to its original position. The term is also applicable to bonds and commodities, in addition to stocks.

Figure 1: Dead cat bounces on gold futures. Source: COMEX
Figure 1: Dead cat bounces on gold futures. Source: COMEX

The purpose of identifying a dead cat bounce is to determine whether or not the price of a stock or other asset that has been decreasing for an extended period of time but is now increasing will continue to decrease. A trader who has previously sold a stock “short” and believes that a subsequent price gain is nothing more than a “dead cat bounce” can decide to keep the short position open. If, on the other hand, a trader believes that a price movement is part of an ongoing upward trend, then the trader needs to close out his short position.

Having said so, it is nevertheless of the utmost importance to have an understanding of a number of the key concepts utilized by technical analysts. Think about whether a stock whose price has been falling is making a comeback because the company's business is becoming better, or whether the stock is garnering interest because it seems inexpensive after a prolonged downturn.

Dead Cat Bounce, The History of the Term

The term first appeared in the United Kingdom in the 1980s, amid a period of economic stagnation – The earliest instance of a quote being found was on December 7, 1985, in an article written by Chris Sherwell for the Financial Times.

“Despite evidence of buying interest yesterday, they said the rise was partly technical and warned against concluding that recent market declines were over. This is what we call a ‘dead cat bounce,' said one broker bluntly.”

It is also interesting to note that the term is often used to describe a politician or program in political circles whose support experiences a minor positive comeback after a sharp and swift fall. This may happen after the support for the politician or program has decreased.

An Example

In 1987, the stock market had a “dead cat bounce” that is considered to be among the most momentous of all time. On October 19, 1987, the Dow Jones Industrial Average (DJIA) saw the worst one-day percentage drop in its history, plunging 22.6%. This was the largest one-day drop in history. A large number of investors were under the assumption that a new bear market was about to occur; nevertheless, the Dow quickly recovered and reached all-time highs. The term “dead cat bounce” refers to this particular kind of rebound.

Identifying a Dead Cat Bounce

It is crucial for investors to be aware of the possibility of a dead cat bounce so that they are not caught off guard. Speculators on the market are frequently individuals who anticipate a rebound to cover their own bets, which can be difficult to recognize. Thus, investors may be enticed to leap on an investing opportunity before it makes sense to do so since a dead cat bounce is frequently a misconception of genuine inherent value.

An investor might be able to accurately recognize a dead cat bounce with the aid of the following typical sequence of events:

  1. The price of a security continues to fall over time.
  2. For a limited period of time, there is an increase in the price.
  3. The price of the security starts to decline again, falling to a level that is lower than the prior low price.

Due to these traits, it is unfortunately rather simple to confuse a dead cat drop with a potential investment opportunity. The fact of the matter is that there is no foolproof method for telling the difference between a dead cat bounce and a full market rebound. It is typically far simpler to see this pattern after the occurrence, as opposed to while it is actually taking place in the here and now.

The Challenges of Timing the Cat

In summary, the cat bounce trading approach is challenging to implement due to the complexity involved in confirming the pattern. If technical stock analysis was always accurate, investing in the stock market would be a simple way to become wealthy. Attempting to time the market entails pinpointing the bottom of a stock price or the beginning of a price rally.

Instead of engaging in such dangerous approach and risking mistaking a dead cat bounce for an opportunity, investors are usually better served by purchasing and holding the shares of companies with strong fundamentals.

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