There's an old saying in investing: even a dead cat will bounce if it is dropped from high enough. The dead cat bounce refers to a short-term recovery in a declining trend. In this article, we explore this phenomenon by looking at an example of a dead cat bounce and contrasting it to an actual change in sentiment that turns a market's outlook from bearish to bullish.

What Is a Dead Cat Bounce?
Let's take a look at a period of economic turmoil:

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As you can see, the markets took a serious beating during this six-week period in 2000. As gut-wrenching as this was, it was not a unique occurrence in financial history. Optimistic periods in the market have always been preceded and followed by pessimistic or bear market conditions, hence the cyclical nature of the economy.

However, a phenomenon unique to certain bear markets, including the one described above, is the occurrence of a dead cat bounce. After declining for six weeks in a row, the market showed a strong rally. The Nasdaq in particular posted gains of 7.78% after a disappointing string of losses. However, these gains were short-lived and the major indexes continued their downward march. This chart illustrates just where the cat bounced, how high it bounced and then how far it continued to fall.

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What Causes A Cat To Bounce?
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 his or her 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.

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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. (Picking market bottoms takes some technical know-how. Check out Market Reversals And How To Spot Them to learn more.)

It is crucial to understand that a dead cat bounce can affect investors in very different ways, depending on their investment style.

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 these two principles should provide some 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 portfolio to bonds, you are ensuring that a portion of your invested assets are 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. (For more on asset allocation, check out the article Asset Allocation Strategies.)
  • A long-term time horizon should calm the fears of those invested in stocks, making the short-term bouncing cats less of a factor. Even if you see your stock portfolio lose 30% in one year, you can be comforted by the fact that over the entire 20th century the stock market has yielded a yearly average between 8-9%.

Conclusion
Downward markets aren't fun at the best of times, and when the market toys with your emotions by teasing you with short-lived gains after huge losses, you can feel pushed to the limit. If you are a trader, the key is to figure out the difference between a dead cat bounce and a bottom. If you are a long-term investor, the key is to diversify your portfolio and think long term. Unfortunately, there are no easy answers here, but understanding what a dead cat bounce is and how it affects different participants in the market is a step in the right direction.

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