Dead cat bounce investing 101

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This can be a result of traders or investors closing out short positions or buying on the assumption that the security has reached a bottom. A dead cat bounce is a price pattern that is usually recognized in hindsight. Analysts may attempt to predict that the recovery will be only temporary by using certain technical and fundamental analysis tools.

A dead cat bounce can be seen in the broader economy, such as during the depths of a recession, or it can be seen in the price of an individual stock or group of stocks. Short-term traders may attempt to profit from the small rally, and traders and investors might try to use the temporary reversal as a good opportunity to initiate a short position.

Similar to identifying a market peak or trough, recognizing a dead cat bounce ahead of time is fraught with difficulty, even for skilled investors. In March , for example, economist Nouriel Roubini of New York University referred to the incipient stock market recovery as a dead cat bounce, predicting that the market would reverse course in short order and plummet to new lows.

Instead, March marked the beginning of a protracted bull market , eventually surpassing its pre-recession high. Examples of a Dead Cat Bounce Let's consider a historical example. Cisco saw many dead cat bounces in the ensuing years. A more recent example is the price action in the market following the onset of the global COVID pandemic in the Spring of Between the week of Feb. Only later, during the summer of , did markets recover. Limitations in Identifying a Dead Cat Bounce As mentioned above, most of the time a dead cat bounce can only be identified after the fact.

This means that traders that notice a rally after a steep decline may think it is a dead cat bounce when in reality it is a trend reversal signaling a prolonged upswing. How can investors determine whether a current upward movement is a dead cat bounce or a market reversal? If we could answer this correctly all the time, we'd be able to make a lot of money. The fact is that there is no simple answer to spotting a market bottom.

A dead cat bounce typically lasts only a few days, although it can sometimes extend over a period of a few months. What Causes a Dead Cat Bounce? Reasons for a dead cat bounce include a clearing of short positions, investors incorrectly believing the bottom has been reached, or from investors trying to find oversold assets. Ultimately, the dead cat bounce is not founded on fundamentals and so the market continues to decline soon after.

There comes a time in every bear market when even the most ardent bears rethink their positions. When a market finishes down for six weeks in a row, it may be a time when bears are clearing out their short positions to lock in some profits. Meanwhile, value investors may start to believe the bottom has been reached, so they nibble on the long side.

The final player to enter the picture is the momentum investor, who looks at their indicators and finds oversold readings. All these factors contribute to an awakening of buying pressure, if only for a brief time, which sends the market up. Dead Cat or Market Reversal? As we noted earlier, after a long sustained decline, the market can either undergo a bounce, which is short-lived or enter a new phase in its cycle, in which case the general direction of the market undergoes a sustained reversal as a result of changes in market perceptions.

This image illustrates an example of when the overall sentiment of the market changed, and the dominant outlook became bullish again. If this could be answered correctly all the time, investors would be able to make a lot of money. The fact is that there is no simple answer to spotting a market bottom. It is crucial to understand that a dead cat bounce can affect investors in very different ways, depending on their investment style.

It's critical to understand market fundamentals to determine if an uptick in the market is a dead cat bounce or a market reversal before making further investment decisions. Style and Bouncing A dead cat bounce is not necessarily a bad thing; it really depends on your perspective.

For example, you won't hear any complaints from day traders , who look at the market from minute to minute and love volatility. Given their investment style, a dead cat bounce can be a great money-making opportunity for these traders. But this style of trading takes a great deal of dedication, skill in reacting to short-term movements, and risk tolerance.

At the other end of the spectrum, long-term investors may become sick to their stomachs when they bear more losses just after they thought the worst was finally over. If you are a long-term, buy-and-hold investor, following two principles of investment diversity and long-term horizons should provide some solace.

Finding Solace A well- diversified portfolio can offer some protection against the severity of losses in any one asset class. For example, if you allocate some of your portfolios to bonds, you are ensuring that a portion of your invested assets is working independently from the movements of the stock market. This means your entire portfolio's worth won't fluctuate wildly like a torturous yo-yo with short-term ups and downs. A long-term time horizon should calm the fears of those invested in stocks, making the short-term bouncing cats less of a factor.