Dead Cat Bounce

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Dead Cat Bounce Meaning

A dead cat bounce (DCB) occurs when the prices of tradable assets increase temporarily after a period of decline and then fall again terribly to continue the downtrend. Unfortunately, many investors confuse this rise with an indication of recovery, leading them to invest in the asset only to incur huge losses after the prices drop further.

Technical indicators, experience, and time play a crucial role in determining whether a declining stock’s sudden upward movement is an actual recovery or instance of DCB. The appearance of a dead cat bounce pattern is usually found during a bear market. It indicates the price of a company during a down time in the market.

Dead Cat Bounce Meaning

A dead cat bounce is when the stock prices rise temporarily, following a steady decline that continues for weeks, showing a pseudo reversal or upward movement in the market. After a while, the price hits a new low, continuing the downtrend.
Many investors often mistake DCB for an actual recovery leading to financial losses. One can confirm an instance of DCB only after it has taken place.
Technical indicators, experience, and time play a crucial role in determining whether a declining stock’s sudden upward movement is an actual recovery or instance of DCB.
Usually, if a stock price lowers to at least 5% of the opening price, it could indicate the DCB. Even in the case of volatile stocks, the decline usually needs to be over 5%.
The causes of DCB can be the dominance of the bears, clearing out short positions, and a sudden increase in the buying pressure.

Dead Cat Bounce Explained

Dead cat bounce is when a company’s stock shows a slight improvement amidst a serious decline in its market value. It comes from the idea that even a dead cat would bounce if it fell from a great height.

A dead cat bounce stock appears when the investors book their losses as the perception of the stock having reached its bottom seeps into their psychology.

The price pattern indicated on an index reflects the current status of the market. The ups and downs in the chart keep investors and money managers up to date. It also helps them make crucial financial decisions ahead. A bearish market is more prone to DCBs. Individual stock, overall market, options, etc., can be a victim of DCB.

Let us understand the concept of dead cat bounce with a simple example.

The stock of a clothing brand, CLO, had been doing phenomenal, earning a peak in its price at $1000 per share. However, following the news of a series of scams at CLO, its stock price fell abruptly to $300. Despite the management’s efforts, CLO’s stock price fell, leading to a downtrend.
Investors began to sell their short positions to reap profits. Short positions help bearish traders gain from a loss-making stock. Long position investors who benefit from a profit-making asset also pitched in.
Long position investors thought the price had reached its extreme low and bought shares hoping that the price would grow. This movement around CLO’s stock pushed up its price to $400.
This rally in the price appeared to be a reverse trend to some investors. However, those exercising caution remained wary as they were apprehensive of being a DCB. After a short-lived recovery, CLO’s stock price fell significantly, hitting its lowest in 30 years at $100.
This indicated that the downtrend had continued, and the brief price recovery was an instance of dead cat bounce. Much like the phrase that even a dead cat bounces, a declining asset might experience a sudden price burst.
There were instances of a slight recovery in CLO’s stock; however, the price continued to fall due to resistance. After two years, the stock eventually recovered, hitting $400, and went into an uptrend.

It isn’t easy to differentiate between a DCB and actual recovery. DCBs can only be realized when they have occurred, but trading experts and analysts stay on the lookout. Technical tools, overall market performance, important news from the financial institutions, experience, and time, are some ways to help understand the movement of DCB. For example, experts are cautious of market volatility in the aftermath of the Covid-19 that has left many economies in shambles. Conversely, an underperforming market loaded with economic debacles is more likely to incur a DCB.

Also, for the price of any tradable asset to be considered for a dead cat bounce pattern, if a stock price lowers down to at least 5% of the opening price, it could be an indicator of the DCB. Even in the case of volatile stocks, the decline usually needs to be over 5%.

Causes of Dead Cat Bounce

Despite the stock being on a downward trend, it is fascinating now there is a brief hike in its market value. The causes of such a hike could be due to various factors. Let us understand the causes of dead cat bounce pattern through the discussion below.

#1 - Negative Dominance

When bulls dominate the stock market, they make it economically sound. However, when the bears become dominant, the stock value downtrend leads to a steady decline. The bears are the pessimist investors who are suspicious of the market. They assume that the values will degrade in the coming times, and hence, they tend to change their purchase behavior. It leads to a rise in the value, forming a dead cat bounce pattern.

#2 - Clearing Out

The fluctuation observed in the trade market is quite a common phenomenon. But when a stock keeps declining continuously, leading to a steep low slope in the chart, certain investors become active. These investors are bear, short-term, short-sellers, and even some value investors. With the short position buyers increasing in number after a steady downtrend, a sudden rise in the stock prices is observed, leading to a DCB.

#3 - Buying Pressure

The momentum investors begin creating long positions post-analysis of the oversold readings. It enhances the purchase of the long stocks, thereby increasing the buying pressure leading to DCB. After a period of decline, the sudden increase in sales figures is reflected in a rise in the stock value.

The TradingView chart of Ujjivan Financial Services is given below, where a Dead Cat Bounce pattern is visible. Considering the price movement during 2020 - 2022, at the beginning of 2020, there was a significant fall in prices; where even though the safe investors had stayed away from the stock, some short traders must have taken advantage of the movement to make huge profits by shorting the stock at this time. This might have triggered a sudden upward movement of the stock from around mid-2020, leading to a level that recovered from the fall by almost half. This phenomenon proves the pattern discussed above because of a sudden increase in prices and revenue for the company. However, the prices could not hold for a longer duration because of the Covid situation arising within the country, which affected the overall market in a very significant manner. Thus, there is a fall again. However, the concept of Dead Cat Bounce has successfully played out in this case.

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Examples

Let us understand the concept of a dead cat bounce stock with the help of a couple of examples.

Example #1

Multiple amateur investors were looking to start with small investments in the trading market. Hence, they bought the short positions sold by the bears. This sudden increase in the buying pressure led to the temporary upward movement in the value of tradable assets following a continuous decline for weeks.
Some investors often refer to DCB with varied expressions such as false hope, fake rally, etc. Many reports have talked about the series of false hopes happening before and during the Great Depression. As per a Fortune piece, there was a 47% rally between late-1929 till early 1930. Before the 47% short-lived recovery, the stocks had fallen 45%. However, the false hope lasted only a bit before the stocks fell by more than 80%. There were false hopes, and the dot-com bubble burst even during the bear markets of 1973-1974 and 2000-2002. Investors worldwide suffered greatly due to such crashes, with many firms going out of business.

Example #2

Following a detailed report from the Hidenberg Research, the shares of the Adani Group, one the largest group of companies in India fell sharply. Its CEO Gautham Adani’s net worth crashed by $27 billion and was left with $92 billion after the 31% crash.

Following the series of news, the investors of the Adani group felt the panic in holding the stock and a large volume of shares were sold. As a result, a head and shoulders pattern were formed. The Relative Strength Index (RSI) had formed a bearish pattern and therefore, experts suspect a dead cat bounce pattern was being formed and the stock would continue to decline after the short hike.