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Understanding Dead Cat bounces: A Stock Market Indicator

The dead cat bounce describes a financial phenomenon whereby a stock in a steady decline suddenly, and without a logical cause, gains value temporarily before continuing its downward trend. The term originates from the saying that even a dead cat will bounce if dropped from high enough.

Summary

The dead cat bounce is a sudden and temporary increase in stock price caused by investors erroneously believing that the stock price’s reached its lowest.
The dead cat bounce can only be fully accurately determined with concrete data in hindsight.
Both falsely identifying a stock price trough (i.e., falling victim to a dead cat bounce) and falsely identifying a true price trough as a dead cat bounce will result in negative financial consequences.

True Price Trough vs. Dead Cat Bounce

True Price Trough

Successful investors are able to discern incipient companies and buy their stocks before other investors become aware of the company’s profitability.

As stock prices reflect the profitability of businesses in the eyes of investors, the basis of the stock price should reflect a business cycleBusiness CycleA business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its long-term natural growth rate. It explains the. Thus, a hallmark of a great investor is the ability to correctly identify the trough of a business cycle early and pinpoint a stock when its share price’s reached its lowest.

When the public becomes aware that certain stocks are already at their lowest price levels, many investors will start to buy, and the price of the stocks will increase to adjust to the new demand. Then, the prescient investors who bought earlier can opt to either hold or sell the stocks for a gain. Colloquially, it is known as “buying low and selling high.”

Dead Cat Bounce

Unfortunately, while businesses are going through the business cycle, there can be fluctuations in their stock prices. Sometimes, investors erroneously identify a fluctuation as the price trough and purchase stocks when the prices of the stocks are still decreasing.

When many investors commit the error, an intrinsic demand is created and can cause a temporary spike in the stock price.

It’s important to reiterate that the increase in stock value is not due to bright company prospects. Instead, the increase is due to mistakenly assuming that the stock price’s reached its lowest and will start to increase.

An Example During the 2008 Financial Crisis

The True Low of the Dow Jones Index

During the 2008 Global Financial Crisis2008-2009 Global Financial CrisisThe Global Financial Crisis of 2008-2009 refers to the massive financial crisis the world faced from 2008 to 2009. The financial crisis took its toll on individuals and institutions around the globe, with millions of American being deeply impacted. Financial institutions started to sink, many were absorbed by larger entities, and the US Government was forced to offer bailouts, the Dow Jones Industrial Average (DJIA) dropped to a low at the beginning of 2009 (indicated by the blue circle). It was an optimal time to buy assets included in the Dow Jones as the market index continued to rise from that point on, providing investors an opportunity to sell high in the future.

The Dead Cat Bounce for the Dow Jones Index in 2008

There was another increase (indicated by the orange circle) in the DJIADow Jones Industrial Average (DJIA)The Dow Jones Industrial Average (DJIA), also referred to as "Dow Jones” or "the Dow", is one of the most widely-recognized stock market indices. mid-2008 that was not reflective of the index price recovering. Instead, it was a falsely identified price trough.

Understanding Dead Cat bounces: A Stock Market Indicator

Investors who believed that the economy was recovering purchased shares and fabricated demand for the assets in the Dow Jones Index. The fabricated demand can be seen from the graph above as the temporary spike in the price. However, as it was a dead cat bounce, the price continued to plummet shortly after the sudden rise.

As you can see, the investors who decided to buy stocks of the assets included in the DJIA during the dead cat bounce in 2008 likely did not benefit.

Caveats of the Dead Cat Bounce

1. Difficult to indicate

The most prominent issue with the dead cat bounce is that it cannot be identified with certainty until it is analyzed in hindsight.

Although many financial analystsFinancial Analysts - What Do They Do try to use statistical tools to forecast such an occurrence and to prevent negative consequences for investors, it’s not possible to be definitive until sufficient time passes, and there are enough data for rigorous financial and economic analysis to concretely label a dead cat bounce.

2. Length of dead cat bounces

Dead cat bounces can vary greatly in length of time. An occurrence of a dead cat bounce (i.e., a sudden and false increase in stock prices) can go anywhere from a few days to several months.

The unpredictability of a dead cat bounce furthers the difficulty of correctly identifying a dead cat bounce.

Erroneous Identification of the Dead Cat Bounce

In the first section, we demonstrated that investors buying stocks on the assumption that a stock price’s reached its lowest could lead to a dead cat bounce.

On the other hand, erroneously identifying a dead cat bounce (when it is actually a stock price trough) leads to missed buying opportunities, and thus also carries negative consequences for investors.

Understanding Dead Cat bounces: A Stock Market Indicator

An example would be falsely identifying the Dow Jones Index trough (circled in the blue circle above) as a dead cat bounce and missing the opportunity to buy the assets before the stock prices started to increase.