What is a Dead Cat Bounce in Investing?

Images from GettyImages; Illustration by Hunter Newton/Bankrate

There are many ways investors attempt to predict future stock price movements. One of these tactics is to identify dead cat impact – a term based on the theory that even a dead cat would bounce if it fell from a sufficiently high height at a sufficiently high speed.

In investing, a dead cat bounce is a temporary recovery in an asset’s price during a prolonged decline. For example, the price of a stock begins to fall, temporarily rises, and then continues to fall. These short and often strong spikes within a downtrend are also known as a “sucker rally” or “bear market rally.”

Here’s what you need to know about a dead cat bounce and what investors can learn from a dead cat bounce, even though it is generally only recognized in hindsight.

What is a dead cathopper?

A dead cat bounce is a short-lived recovery in the price of a falling asset immediately after a significant, long-term decline but just before the price resumes its downward trend. A dead cat bounce typically occurs after a long-term period of market decline.

Here are some reasons why a dead cat bounce can occur.

• Market news: Financial markets are influenced by news and speculation. After a long-term decline, positive news about an asset could push the price higher.
• Taking profit: When a stock temporarily recovers after a decline, some investors sell their shares to take profits. This sale can also push the price up for a short time, even if the overall trend remains negative.
• Basic Weakness: In a dead cat bounce, temporary price increases are typically not supported by the asset’s fundamentals, or underlying economic conditions may be weak. In other words, the increase is caused by an external factor, a la Roaring Kitty and the GameStop run-up, rather than a company’s financials. Factors such as reduced revenue or increased competition may contribute to this weakness.
• Speculation: Technical day traders look for patterns to spot and buy a recovery, prompting other investors to do the same in hopes of profiting from the momentum. Some investors simply bet on a short-term recovery without evaluating the asset’s fundamentals and instead use other indicators, such as: B. moving averages.
• Optimism: After a market downturn, investors may hope that the worst is over and buying pressure increases with increasing optimism, resulting in a rapid and short-lived increase in a stock’s price even though the underlying fundamentals or economy are weak.

What does a dead cat bounce tell investors?

A dead cat bounce is usually only recognized in hindsight, when time shows how the price has developed. However, a dead cat bounce could indicate that a temporary recovery without a concrete reason could be short-lived and a long-term price increase is not in sight. The brief rise could also be a signal to investors of caution regarding the overall market and general economic conditions.

Of course, there is the possibility of a false alarm. By definition, a dead cat bounce occurs when the price of an asset continues to decline after a brief increase. If an asset does not continue its downward trend, it may be headed for a true recovery or may instead level off. Again, only time will tell, although data – such as a strong or weak earnings report – can indicate whether the increase is justified or not.

Dead cat jump example

In mid-2008, the Dow Jones Industrial Average (DJIA) was on an absolute tear – falling steadily from around 13,000 in April, rising to around 11,700 in August, and then falling back down to a low in the mid-6,000s in early 2009 Although the Dow itself is an index and not an asset like stocks or bonds, it serves as a valuable indicator of overall market sentiment and health.

Some investors, fueled by optimism, believed the economy was on the mend and not headed for recession, prompting buying and pushing the index higher. However, shortly after this brief rise, the index bottomed out.

When the index recovered, it gave investors false hope. Several economic indicators – such as lower unemployment and GDP growth – looked promising, but underlying market fundamentals were weak amid the Great Recession.

Hindsight is 20/20 when it comes to identifying a dead cat bounce, but these past bounces illustrate the importance of recognizing that market rallies can be short-lived and that sometimes there are bigger problems at play .

How is a dead cat bounce different from fundamental analysis?

A dead cat bounce falls into a category of investment analysis called technical analysis. It is a method that focuses on analyzing price movements and trading volumes to predict future price behavior. Investors often use historical data, charts, moving averages and other data to determine these price movements.

Fundamental analysis, on the other hand, is a research method that investors use to determine the intrinsic value or true underlying value of a stock or asset. Fundamental analysis calculates this value by analyzing factors such as sales, profit and profit margin. The goal is to determine whether a stock is overvalued (valued higher than its intrinsic value) or undervalued (valued lower than its intrinsic value). Fundamental analysis focuses more on the underlying economic factors and financial metrics that go into analyzing a long-term investment rather than a short-term purchase, sale or trade.

Conclusion

A dead cat bounce is a short-lived increase in the price of a falling asset, followed by another sharp decline. This can happen due to news, market speculation, or weak fundamentals. In general, investors should be cautious when investing in an asset based on a short-term price increase. Instead, long-term investors should focus on the fundamentals of the asset and not just rely on price performance.