Dead Cat Bounce

It refer to a phenomenon in finance where a stock that is following a steady downward trajectory temporarily gains value for no logical reason and then proceeds to continue falling.

The dead cat bounce refers to a phenomenon in finance where a stock following a steady downward trajectory temporarily gains value for no logical reason and then proceeds to continue falling.

dead cat bounce

The phenomenon's name is based on a simple idea. Even a dead cat will bounce if it is dropped from a high enough point and falls at a fast enough pace. The dropped cat will bounce up and fall back down because it is lifeless.

This is a classic example of what is widely known as the "sucker rally," a brief increase in the price of a certain stock or the market as a whole. But, unfortunately, it is only long enough for "suckers" to get on board before the market falls again.

Not supported by the fundamentals of finance, this rally is short-lived.

These patterns are typically quite hard to spot in real-time and only become apparent after the rally.

Only after the stock price drops for the second time can investors determine whether the price increase was a sustainable recovery in the company's share price or simply a dead cat bounce.

However, the phenomenon is not restricted to stocks. It can occur in any financial asset, like an index, currency, cryptocurrency, or commodity. It is also sometimes seen in the economy as a whole, such as during a recession.

If traders buy into the rally too quickly before waiting to ensure it is sustained, they will likely face huge losses. Hence, most experienced investors or traders wait before jumping into any trade.

Causes

This phenomenon is seen as a continuation pattern according to technical analysis. At first, it may appear that the bounce is signaling a reversal of the previous downward trend, but it quickly reverts to the same falling trajectory.

stock falling

Once the price drops below its previous low, the phenomenon is said to have occurred.

Identifying this phenomenon while still happening is difficult, if not nearly impossible.

In fact, economist Nouriel Roubini described the beginning of the stock market's recovery as a "dead cat bounce" in March 2009. He predicted that the market would quickly go back to declining and even plunge to new lows.

Instead, March 2009 marked a long-lasting bull market that eventually surpassed its pre-recession peak.

One of the most common causes of this phenomenon is traders' herd mentality. If the price increases even slightly, traders may assume that the stock is recovering. 

With the assumption that other traders are also buying into the stock because of its recovery, a trader will purchase shares hoping to have bought the dip before a long-term upward trajectory.

These traders make purchases under the false impression that the security has reached its lowest point and will now rise.

Sometimes, momentary price increases are also a result of short positions being closed out by traders or investors. 

Examples

To strengthen our understanding of this interesting financial market phenomenon, let us look at a few examples.

cars

We first consider a hypothetical example. Suppose a publicly traded car rental company is experiencing a downward trend. One day, its price drops from $80 to $60 to $55. Then, one day, the price rapidly rises to $70 and drops to $50. 

Since the price fell to a point lower than its previous low, the car rental company's shares are said to have experienced a dead cat bounce.

This way, it is fairly easy to spot the phenomenon after it has already occurred.

Now, let us consider a real-life example, specifically that of the Standard and Poor's (S&P) 500 index at the onset of the coronavirus pandemic.

globe

The index was declining between February and March 2020 as the news of the pandemic was making headlines across the globe. 

As businesses were forced to shut down, markets were falling, and investors remained wary of a potential recession.

However, in the middle of these declines, there were a few days when the S&P 500 index rose. Some believed that the index was rising after reaching a bottom. 

Ultimately, prices went back to declining in the days following. The short rally in stock prices was just a dead cat bounce.

Differences between a true price trough and a dead cat bounce

A price trough is when market prices hit their lowest level before they begin to rise again. Often, this phenomenon may be confused for a price trough, and investors or traders acting on this belief incur hefty losses.

trading

Experienced investors can successfully identify emerging businesses and purchase shares in them. They often do so before other investors learn about the business's profitability to make a profit.

This ability to correctly predict the bottom of a business cycle and locate stock at its lowest point is a sign of a great investor. Stock prices are reflective of a business cycle; therefore, timing them is key to obtaining profits.

When investors learn that equity is trading at its lowest point, they rush to purchase the stock. This increased demand, causing the price of the stock to rise.

These events occur during a true price trough. It presents an opportunity to gain from the markets.

On the other hand, a dead cat bounce occurs when some investors mistakenly identify a fluctuation in the stock price as a true price trough. As a result, these investors end up purchasing while prices are still falling.

When this happens, the company's share price spikes temporarily, leading to the dead cat bounce phenomenon.

The rising stock value is not a result of the business's promising potential. Instead, it is merely because some investors falsely believed that the stock price had dropped to its lowest point and would soon begin to rise.

Limitations of the phenomenon

Like any other phenomenon in the world of finance, it has its shortcomings when it comes to technical analysis. The following section briefly goes over some of these.

Limitations

  • As discussed in previous sections, this phenomenon can be very hard to spot, so much so that it may lead experienced economists to make false claims. Moreover, it can only be distinguished with certainty after losses have already occurred.
  • Although many financial analysts attempt to predict such events using statistical tools, it is impossible to be certain until enough time has passed.
  • Further, incorrectly identifying whether the market has reached a trough can lead to missed opportunities for investors and is often accompanied by dire financial consequences.
  • The duration of a dead cat bounce can vary greatly. A fast and erroneous surge in stock prices can happen at any time and last between a few days to several months.
  • The opposite of this phenomenon is the inverted dead cat bounce. Investors or traders engage in a temporary but harsh sell-off of a company's shares, even while the market is bullish.
    This can also have severe financial consequences on the investor.
  • All in all, attempting to time a market bottom is both risky and difficult.

Potential trading strategies

From the limitations discussed in the previous section, it is clear that timing the market isn't an easy practice when investing in companies shares. 

Trading Strategies

It is better to avoid going against the market to prevent losses, especially when more news is being released about the company.

For this reason, one of the best trading strategies to adopt when trying to avoid falling into this phenomenon's trap is to "follow the crowd." 

As the name suggests, it simply means doing what other investors do in the overall market.

However, it is important to understand why a company is performing well/poorly and what attracts investors.

For example, a rally in electric vehicles or clean energy stocks may be attributed to the growing popularity of ESG investments. 

Further, the introduction of the Inflation Reduction Act suggests that economies are shifting away from fossil fuel companies and towards greener ones.

Essentially, before investing, it is wise to understand the fundamentals behind what is driving the price of that particular asset. However, relying solely on technical analysis may not be a profitable strategy in the long run.

Another way to protect yourself against this phenomenon is to learn how to identify when a trend in stock prices is approaching its end.

When a trend ends, investors unable to foresee its culmination often suffer. In such situations, employing technical analysis, such as looking at fluctuations in an index, is usually helpful.

If an index that has been on the rise for a long period starts to show signs of a decline, it could mean that more investors are likely to begin selling their assets.

Summary

The following section recaps what we learned throughout this phenomenon discussion. Mentioned below are our key takeaways:

cat

  • A dead cat bounce refers to a situation where a company's stock price on a downward trajectory rises for a brief period before falling back down.
  • During the recent onset of the Coronavirus pandemic, the financial markets are a good example of how the phenomenon may occur and throw off investors.
  • It is important to note the difference between a true price trough and a dead cat bounce. 
  • While a true price trough shows that the stock has reached its lowest point and will now rise, a dead cat bounce can create the incorrect belief that a true price trough has been reached.
  • There are several drawbacks to the phenomenon. One of the major drawbacks is that it can be very difficult to tell when it occurs accurately. Often, investors only realize the phenomenon occurred after the fact.
  • Investors or traders wrongly identify this phenomenon as a price trough that could incur hefty financial losses.
  • Adding to the difficulty of determining this phenomenon is the fact that it can vary greatly in duration. Sometimes it lasts for only a few days while, other times, it may extend for many months.
  • The inverted dead cat bounce occurs when investors sell off a significant amount of a company's assets when the market is on an upward trend. This creates a temporary dip and can also result in losses for investors.
  • To avoid losses due to this phenomenon, it is a good idea to adopt trading strategies such as "following the crowd." 
  • Ultimately, you must identify the key factors driving a company's prices before purchasing shares in it. This increases the probability of profiting.
Financial Statement Modeling Course

Everything You Need To Master Financial Statement Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and authored by Rhea Bhatnagar LinkedIn

Reviewed and edited by James Fazeli-Sinaki LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: