What Does a Dead Cat Bounce Mean for Markets?
Financial markets have seen a lot of volatility in recent years. Some investors use technical indicators such as price and chart patterns to understand and trade on that volatility. A dead cat bounce is one of those patterns.
The concept of the dead cat bounce is used in technical analysis to identify temporary recoveries that aren’t indicative of a long-term bullish stock market.
What is a Dead Cat Bounce?
A dead cat bounce (DCB) is a temporary rally of asset prices in a bear market that is followed by a continued downward trend. It is sometimes called a “sucker’s rally.”
To be considered a dead cat bounce, the price of a stock must fall to new lows after the short-term recovery.
The phrase comes from the pretty morbid concept that if you drop a dead cat, it will bounce before it eventually stays on the ground.
In financial markets, downtrends are rarely direct falls to bottomed-out prices. They are often broken up with small periods of relief where prices temporarily rise before further falling, or beginning to climb again.
How Long Does a Dead Cat Bounce Last?
A dead cat bounce can last for as little as a few minutes or as long as a few months. Typically, they’ll last a few days as the phenomenon is caused by a short-term rally of investors attempting to buy the dip and not by any fundamentals.
Identifying a Dead Cat Bounce Pattern
While we can never be sure if an asset’s upward movement is temporary or long-term until after it’s already fallen back down (or stayed strong), some signs indicate a temporary recovery instead of a fundamental reversal.
Dead cat bounces typically happen when a financial asset declines sharply and quickly. After the downturn, there is a momentary gain in price, followed again by steady downfall. This order of events can make it difficult to properly identify the pattern in real-time.
What is important to keep in mind is that these temporary gains in price are not based on a rise in the intrinsic value of an asset but just on investor sentiment.
What Does a Dead Cat Bounce Indicate?
Like many economic events, dead cat bounces can only technically be identified after the fact. The bounce is a short-term price increase that is preceded and followed by a decline. The second decline brings the share price to new lows.
There’s no way to know for certain if a price increase is temporary or not. In this case, we don’t know for sure if it’s a dead cat bounce until the second price decline.
Technical analysts look at dead cat bounces as price patterns, specifically, it is considered a continuation pattern. This means the bounce can first look like a price trend reversal but is quickly followed by a continuation of the downtrend.
It becomes a dead cat bounce after the price drops below its previous low.
What Causes a Dead Cat Bounce?
Downtrends frequently see temporary periods of recovery. This can result from traders or investors closing out short positions or attempting to buy the dip, believing the asset has reached its bottom.
Essentially, investor sentiment about future price movement can cause brief rallies. The dead cat bounce isn’t caused by fundamentals, just market speculation.
Examples of a Dead Cat Bounce
One recent example is the price action on Wall Street directly following the beginning of the COVID-19 pandemic lockdowns. Consumer and investor panic led to market volatility, causing stock prices to fall quickly — 12% in one week.
There was a brief pause of declines as markets rose 2% the following week. While some could have read into this as a sign of recovery, it was only a dead cat bounce. The market fell an additional 25% in just the next two weeks.
Another recent dead cat bounce example is the multiple brief recoveries followed by newer lows in the crypto market in the spring of 2021.
The Bottom Line
Stock market volatility and short-term price recoveries are common phenomena. A dead cat bounce is one example of a price pattern that technical analysts and short-term traders utilize to make sense of volatility and understand how to trade it.