What is a Dead Cat Bounce?
Markets are typically in an uptrend or downtrend. In long-term uptrends, there can be short-term corrections or rallies. In bear markets or downward-trending markets, short-term rallies can occur. Such a short-lived price rally is called a dead cat bounce.
A dead cat bounce is a temporary recovery in asset prices in a secular downtrend or bear market. This price rally is usually brief and within a more prolonged technical decline. It reverses, allowing the bear market to continue. The term dead cat bounce derives from the analogy that even when a dead cat drops from a high position, it bounces, but this does not mean it is alive.
Dead cat bounces primarily apply to short-term price increases in individual stocks and market indexes. However, the term can also refer to other asset classes such as commodities and bonds. In stocks, a dead cat bounce occurs due to good news, oversold conditions, or bargain hunters creating demand. These conditions support a quick rally that immediately fades due to a lack of investor enthusiasm. Typically, the stock price will retrace the bounce and quickly sink below the lows set before the bounce.
What does a dead cat bounce mean?
The first use of the term dead cat bounce was by Financial Times journalists Chris Sherwell and Wong Sulong during the 1985 recession, when the Singaporean and Malaysian stock markets rallied hard after a long-term downtrend. A dead cat bounce is also often referred to as a sucker’s rally because buyers are making a mistake. They are lured in by rising prices but will likely lose money as the price action quickly deteriorates and heads to the downside.
During the 2007–2009 bear market, several short-lived dead cat bounces happened as the market declined. However, these bounces were brief, and the market continued its downtrend until it hit its ultimate lows in March 2009. A recent example of a dead cat bounce is the S&P 500 rally in March 2022. After a 14% drop from January 2022, the index rallied from 4,150 to 4,630 in March. However, the market quickly reversed these gains, with the index resuming its bear market and dropping below the March lows by early May 2022.
How to spot a dead cat bounce
It’s difficult to determine whether a stock rally is a dead cat bounce in real-time. A rally can be a trend reversal marking the end of a bear market and pushing the market to new highs, or it can be an intermediate bounce in a bear market. However, looking at a stock chart in hindsight and applying technical analysis, it’s easy to spot a dead cat bounce. First, the price increase is in the context of a longer-term decline or downtrend. The bounce remains within the bearish pattern, and the price doesn’t breach the overhead resistance marked by lower highs. The highest price in a dead cat bounce forms a lower high. After that bounce, the stock price rolls over and declines back to the lows.
A dead cat bounce can happen for a variety of reasons. Good news or improving expectations can attract buyers and lift the price of a stock. Secondly, short sellers may decide to lock in some profits after a prolonged decline in a bear market. Hence as they buy to cover their positions, the market and stocks experience a rally. Thirdly, extreme negative sentiment can lead to oversold conditions. Bargain hunters might view the depressed prices as an opportunity to buy cheap stocks. Also, traders might take advantage of the oversold readings to position for a short-term bounce.
Traders can use technical analysis to identify the likelihood of a dead cat bounce. For example, a highly oversold RSI reading of below 20 may indicate that the selling is overdone, and the price is bottoming. The low RSI forms the basis for a short-term rebound.
Characteristics of a dead cat bounce
Short-term bounce: Dead cat bounces are usually short-lived and occur within a prolonged bear market.
A lower high: The high in a dead cat bounce fails to break overhead resistance. The downward-sloping resistance line anchored on previous highs acts as resistance. The price doesn’t rise above the resistance during a dead cat bounce.
Low volume: Often, dead cat bounces lack fundamental support such as improving earnings or economic outlook. Due to this uncertainty, market participation is limited, and the price rally happens in a relatively low volume.
How long does a dead cat bounce last?
The length of a dead cat bounce depends on the context. For instance, a dead cat bounce may take several months in a prolonged bear market of several years. On the other hand, in short-term bear markets, a two-week rally may be treated as a dead cat bounce.
Dead cat bounces often attract traders who hope for short-term gains. But they risk more downside as the downward trend is the prevailing pattern over the long term.