What Is a Dead Cat Bounce and How Can You Spot It?
A “dead cat bounce” is a colorful way of describing an unexpected price jump that occurs after a long, slow decline — and typically just before another price drop.
A dead cat bounce carries that morbid name because the price spike in a particular stock or market sector isn’t “live” (i.e. it’s not a real rebound), and characteristically it doesn’t last.
The danger can be that the apparent rebound creates false value, or optimism. That said, some investors may be able to take advantage of a dead cat bounce to create a short position. Unfortunately, it’s hard to identify a dead cat bounce until after the fact.
Nonetheless, investors may want to know some of the signs of this price pattern, as it can help them gauge certain market movements.
Key Points
• A dead cat bounce refers to a temporary price jump after a decline, often followed by another drop.
• It is difficult to identify a dead cat bounce in real-time, making it challenging for investors to take advantage of it.
• Dead cat bounces can occur in individual stocks, bonds, or entire markets.
• Investors should be cautious when interpreting price movements and consider other factors before making investment decisions.
• Active investors may use technical analysis and market indicators to help identify potential dead cat bounces.
What Is a Dead Cat Bounce?
The meaning of “dead cat bounce” comes from a bleak saying among traders that even a dead cat will bounce if it’s dropped from a high enough height.
Thus, when a security or market experiences a steady decline, and then appears to bounce back, only to decline again — it’s known as a dead cat bounce. The “recovery” doesn’t have a rhyme or reason; it’s merely part of a short-term market variation, perhaps driven by market sentiment or other economic factors.
Sometimes what appears to be a dead cat bounce can turn into a stock market crash.
A Dead Cat Bounce Is Specific
If you’re learning how to invest in stocks, bear in mind that a dead cat bounce is not used to describe the ups and downs of a typical trading day — it refers to a longer-term drop, rebound, and continued drop. The term wouldn’t apply to a security that’s continuing to grow in value. The revival must be brief, before the price continues to fall.
It’s also important to point out that this financial phenomenon can pertain to individual securities such as stocks or bonds, to stock trading as a whole, or to a market.
Why Identify a Dead Cat Bounce?
Even for experienced traders or short-term investors using sophisticated technical analysis, it can be difficult. Sometimes a rally is actually a rally; sometimes a drop indicates a bottom.
The point of trying to distinguish whether the rise in price will continue or reverse is because it can influence your strategy. If you have a short position, and you anticipate that a rally in stock price will end in a reversal, you may want to hold steady. If you think the rally will continue, you’ll want to exit a short position.
Example of a Dead Cat Bounce
To illustrate a dead cat bounce, let’s suppose company ABC trades for $70 on June 5, then drops in value to $50 per share over the next four months. Between Oct. 7 and Oct. 14, the price rises to $65 per share — but then starts to rapidly decline again on Oct. 15. Finally, ABC’s stock price settles at $30 per share on Oct. 16.
This pattern is how a dead cat bounce might appear in a real-life trading situation. The security quickly paused the decline for a swift revival, but the price recovery was temporary before it started falling again and eventually steadied at an even lower price.
History of Dead Cat Bounces
There are countless examples of the dead cat bounce pattern in stocks and other securities, as well as whole markets. One of the most recent affected the entire stock market during the Covid pandemic.
The U.S. stock market lost about 12% during one week in February 2020, and appeared to revive the following week with a 2% gain. But it turned out to be a false recovery, and the market dipped back down again until later that summer.
Why Does a Dead Cat Bounce Happen?
A dead cat bounce is often the result of investors believing the market or security in question has hit its low point and they try to buy in to ride the turnaround. It can also occur as a result of investors closing out short positions.
Since these trends aren’t driven by technical factors, that’s why the bounce is typically short-lived — usually lasting a couple of days, or maybe a couple of months on the outside.
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How to Spot A Dead Cat Bounce
Because a dead cat bounce is often an illusion of actual intrinsic value, investors may be tempted to jump on an investment opportunity before it makes sense to do so.
The following typical sequence of events may help an investor correctly identify a dead cat bounce as it might occur with a specific stock.
1. There is a gap down.
Typically the stock opens lower than the previous close, usually a significant amount like 5% (or perhaps 3% if the stock isn’t prone to volatility).
2. The security’s price steadily declines.
In a true dead cat bounce scenario, that initial gap down will be followed by a sustained decline.
3. The price sees a monetary gain for a short time.
At some point during the price drop, there will be a turnaround as the price appears to bounce back, close to its previous high.
4. A security’s price begins to regress again.
The rally is short, however, and the stock completes its dead cat bounce pattern with a final decline in price.
Dead Cat Bounce vs Other Patterns
How do you know whether the pattern you’re seeing is really a classic dead cat bounce versus other types of movements? Here are some clues.
Dead Cat Bounce or Rally?
One way to stay alert for a dead cat bounce with a particular stock is to consider whether the now-rising stock is still as weak as it was when its price was falling. If there’s no market indicator as to why the stock is rebounding, it might make sense to suspect a dead cat bounce.
Dead Cat Bounce or Lowest Price?
Since investors are looking for opportunities to profit, they try to find investment opportunities that allow them to buy low and sell high.
Therefore, when assessing investment opportunities, a successful investor might try to recognize emerging companies, and buy shares of their stock while the price is low and before other investors get wind of the lucrative company.
Since companies go through business cycles where stock prices fluctuate, pinpointing the lowest price point might be hard to determine. There’s no way to know if a dead cat bounce is happening, until the prices have resumed their descent.
Dead Cat Bounce or Bottom of a Bear Market?
Investors may also confuse a dead cat bounce for the actual bottom of a bear market. It’s not uncommon for stocks to significantly rebound after the bear market hits bottom.
History shows that the S&P 500 often sees substantial gains within the first few months of hitting bottom after a bear market. But these rallies have been sustained, and thus are not a dead cat bounce.
Investing Strategies to Avoid a Dead Cat Bounce
For investors who want a more hands-on investing approach — meaning active investing vs. passive — it’s generally better to use investing fundamentals to evaluate a security instead of attempting to time the market (and risk mistaking a dead cat bounce for an opportunity).
Investors who are just starting may want to consider building a portfolio of a dozen or so securities. Picking a few stocks allows investors to monitor performance while giving their portfolio a little diversification. This means the investor distributes their money across several different types of securities instead of investing all of their money in one security, which in turn can help to minimize risk.
Active investors could also consider selecting stocks across varying sectors to give their portfolio even more diversification instead of sticking to one niche.
Investors with restricted funds might consider investing in just a few stocks while offsetting risk by investing in mutual funds or exchange-traded funds (ETFs).
For investors who would prefer not to execute an active investing strategy alone, they can speak with a professional manager. Working with a professional manager may help the investors better navigate the intricacies of various market cycles.
Limitations in Identifying a Dead Cat Bounce
As noted several times here, a dead cat bounce can’t really be identified with 100% certainty until after the fact. While some traders may believe they can predict a dead cat bounce by using certain fundamental or technical analysis tools, it’s impossible to do so every single time.
If there were a way to accurately predict market movements or different patterns, people would always try to time the market. But there are no crystal balls in investing, as they say.
The Takeaway
With 20-20 hindsight, investors and analysts can clearly see that an individual security or market has experienced a steady drop in value, a brief rebound, and then a further drop — a phenomenon known as a dead cat bounce.
Unfortunately, though, it can be too hard for most investors to distinguish between a dead cat bounce and a bona fide rally, or the bottom of a given market or security’s price. Still, knowing what to look for may help investors make more informed choices, especially when it comes to making a choice around keeping or closing out a short position.
For investors who want to take an active role in investing, an online trading platform like SoFi Invest® offers the opportunity to manage your money the way you want. When you open an Active Invest account with SoFi, you can trade stocks you’re familiar with or explore different investment opportunities, including IPO shares, fractional shares, and more.
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