Dead Cat Bounce in Investing: Meaning, Reasons, and How to Spot It

UTC by Tokoni Uti · 8 min read
Dead Cat Bounce in Investing: Meaning, Reasons, and How to Spot It
Photo: Depositphotos

In this guide, we break down all about the dead cat bounce pattern, speak on what causes dead cat bounces to happen, and provide you with tips on how to spot one.

Most investors monitor the market to see when is best to buy and sell. Those involved in investing are also probably aware that asset markets can be unpredictable and complex. It is quite easy to get caught up in market movements that seem to be going one way but end up going another. Such is the case of a dead cat bounce – the phenomenon you need to be aware of if you are considering or already involved in investing.

Many investors have been tricked by a dead cat bounce. Therefore, it is important to know what it is and how to spot it. In this guide, we break down all about this pattern.

Dead Cat Bounce Explained

Simply put, a dead cat bounce is a situation when an asset or an entire asset market has been in a long-running decline in price but seems to briefly recover, with the prices going up slightly. This recovery, as we’ve said, is brief, as the asset will return to its downward trajectory soon after, even surpassing its previous low point.

This sort of market movement is tricky since investors (especially those who lack experience) can make investment decisions based on this. Of course, they end up regretting this once the market returns to its previous state.

But why is it called “dead cat bounce”? Well, the idea is that if a dead cat is thrown far enough and fast enough, it will bounce when it hits the ground, briefly giving the illusion of having come back to life. Dead cat bounces are one of those market phenomena that can be explained to a degree but also function, in some ways, like a natural disaster that we can’t control but need to be aware of. And, of course, there are several examples of dead cat bounce throughout history that we will have a look at later on.

History of Dead Cat Bounce

Technically, dead cat bounces would have existed for as long as asset markets themselves have. But the first time that the term was used was in 1985 in the context of stock markets in Malaysia and Singapore. Both countries were going through a recession and several stocks seemed like they were recovering, only to resume their decline.

The term was coined by Financial Times journalists Wong Sulong and Horace Brag who noted the similarities between the stock movements and how even a dead cat would bounce if thrown. As more asset markets saw volatility throughout the 1990s and beyond, the term “dead cat bounce” became more widely used. By the 2000s, it was a part of not just financial language but political as well, sometimes referring to a political candidate whose approval ratings briefly recovered, only to plunge again.

What Leads to Dead Cat Bounce

When trying to understand a dead cat bounce, it is important to know what causes them in the first place. While it is certainly an odd phenomenon at times, there are a few things that are known to cause them.

  • Market sentiments. Take the dead cat bounce that took place at the beginning of the pandemic. No one was completely sure what we were dealing with and after the initial panic set in, some investors might have thought we’d seen the worst of it and began to purchase assets, which could have caused the brief recovery.
  • Re-buying oversold assets. When an asset market is in a freefall, many investors sell them off in mass. Others, at some point, might consider some assets as being oversold and will buy some back. This could trigger a brief recovery before the decline resumes.
  • Short positions. Investors who had opened short positions before the decline might choose to clear them at some point and this can also cause a brief market recovery.

In all of these, it is worth keeping in mind that these factors are not based on the fundamentals of the markets so they cannot sustain a recovery. These reasons always lead the market back to its previous decline and this has immense implications for investors.

What Does It Mean for Investors?

The fact that dead cat bounces exist means that investors need to be cautious of them. Being able to spot the telltale signs of a dead cat bounce is crucial for protecting yourself and your investment.

This is because their existence means that you cannot trust every alleged price recovery you observe in the market. The trap many get caught in is assuming that a dead cat bounce is a genuine recovery and investing based on this. Sadly, one of the major issues with a dead cat bounce is that it cannot be definitively identified until after it has taken place. Because the asset price needs to fall below the initial bottom to be considered a dead cat bounce, they are especially tricky to navigate.

Ultimately, for investors, it means that they have yet another market pitfall to navigate and that they need to be aware of dead cat bounces, lest they lose their money in a fit of false confidence.

Dead Cat Bounce Examples

A look at the asset market over time will reveal several instances of dead cat bounces. A prime example of the phenomenon is 2001 when the stocks for Cisco Systems Inc (NASDAQ: CSCO) fell from $82 per unit to $15.81 during the dot-com bubble burst. In November 2001, the stock rose back to  $20.44, only to fall even lower to $10.48 by September 2002.

A more recent example would be during the COVID-19 pandemic when the US asset markets saw a steep decline in value, beginning in February 2020. In the weeks that followed, the market saw a brief recovery, leading some investors to think that the worst was behind them. Then the markets went back into a freefall and saw declines not experienced in decades. This, again, can be seen as an example of dead cat bounces.

Dead Cat Bounce in Crypto Industry

Just as the traditional asset market can experience dead cat bounces, so can the crypto sector. The same principle applies: a specific crypto or the market as a whole is experiencing a downturn and then appears to have a recovery period. This, however, does not last, as the market returns to its decline, exceeding previous losses. This tends to happen when the market is entering a bear run and could be caused by a few factors. Something might be reported in the media that causes some investors to buy up a stash of crypto or some might choose to stock up on tokens while the price is low and this briefly causes a price increase. In all these cases, the outcome is the same, which is that the spike does not last.

In the same way that investors have to be wary of dead cat bounces in the traditional asset market, they must be vigilant against the same pitfall in the crypto market.

How to Spot a Dead Cat Bounce

If you learn how to spot dead cat bounces when investing, you can avoid falling victim to them. Generally speaking, there are a few telltale signs that an asset is experiencing a dead cat bounce:

  • Low volume. These spikes are caused by brief periods of increased buying but these are not enough to sustain its momentum long term. If an asset that has been declining starts seeing gains, look into the transaction volume driving them. If they are low, it might be a dead cat bounce.
  • Weak spikes. The price spikes that dead cat bounces would produce would be much lower than previous all-time highs and while it might be a relief after a consistent price downturn, they will not benefit you in the long run.
  • Previous market movements. If an asset has been falling for a significant amount of time and suddenly sees a spike in value, it could be an indication of a dead cat bounce. This is tricky because no one can know for certain until after the bounce has happened but be wary of sudden changes in the market movements of an asset.

Bottom Line

Asset markets are very unpredictable and if you are going to operate within them, you need to know what to look out for. One of the big pitfalls to avoid in investing is a dead cat bounce. While it can be tempting to try and take advantage of what looks like a reversal of a downward trend, a dead cat bounce is temporary and has led many investors to make poor decisions.

That is why it is important to understand how these bounces work, how to spot them, and hopefully, avoid making hasty decisions and ending up losing your money.

Share:

FAQ

What is a dead cat bounce?

This is a pattern within the asset market that sees an asset that was previously trending downward make a sudden recovery. But this is short-lived and the asset goes on to make an even bigger decline soon after. 

What are the reasons behind a dead cat bounce?

Dead cat bounces are caused by investors buying oversold assets, clearing short positions, or overall market sentiments. 

Is a dead cat bounce good or bad?

A dead cat bounce could be bad for investors because some might rush to buy the asset thinking that it is making a recovery. 

How long can a dead cat bounce last?

A dead cat bounce usually lasts from a few days to a few months. 

Where does the name "dead cat bounce" come from?

The term “dead cat bounce” was coined by two journalists in the 1980s. However, the initial idea was that if a dead cat is thrown far enough and fast enough, it will bounce when it hits the ground, briefly giving the illusion of having come back to life.

Is it possible to predict a dead cat bounce?

There are a few telltale signs of a dead cat bounce like low transaction volume, weak spikes, and previous market movements but no one can definitively prove a dead cat bounce until after it has happened. 

guides
Essential Guide to Open Banking March 4th, 2024

In this guide, we will explore open banking which holds the promise of making the whole banking process better and discuss the ben...