After falling all the way from 38,090 on September 14 to 34,001 on October 11, the S&P BSE Sensex unexpectedly surged by 732 points this Friday to close higher by over 2 per cent. This move followed a similar rebound in the US and is the highest single-day gain that the index has managed ever since this meltdown started. While some investors were cheering this rise as a turning point in the market rout, others warn that it looks pretty much like a dead cat bounce.

What is it?

Cat lovers may not find it very pleasant to imagine what would happen if they dropped a dead cat from a considerable height. It would likely bounce once and then lie inert. The term ‘dead cat bounce’ is used by market participants to describe a similar, short-lived rebound in stock or asset prices which fails to sustain.

Dead cat bounces are commonplace in any financial asset (it could be stocks, commodities or currencies) where prices have been falling consistently and sharply.

They occur because, after indulging in a selling binge for a while, sellers usually like to take some of their fat profits off the table and close out their old positions, before they can resume their onslaught. A steep fall in an asset can also prompt value investors, who love to pick up assets cheap, to jump in to buy bargains.

Both these factors trigger the sharp but temporary rebounds that go by the moniker of a dead cat bounce. A dead cat bounce can also occur intra-day after a stock opens the trading session with a big gap down.

Why is it important?

Dead cat bounces are the bane of both long-term investors and those who operate on the buy side of the market. They give such investors fleeting hope that a market fall is at end, only to dash it. Investors who aren’t used to bear markets often mistake a dead cat bounce for the start of a new market rally and jump in to commit more of their money. They eventually end up trapped and end up suffering further losses when stock prices resume their southward journey.

For short-term traders or those on the sell side of the market, a dead cat bounce can be a money-making opportunity. If they are sure that the surge is temporary, they can initiate fresh sell positions during the rally making profits off the misguided buyers.

Why should I care?

Any extended bear market in stocks is often interrupted by one or many dead cat bounces. During the global financial crisis-induced stock market meltdown in India, the Sensex, after peaking out at over 21200 on January 10, 2008, fell by a breathtaking 5,800 points over the next nine trading days to 15,300 levels. Over the next 10 trading sessions though, the index rebounded by as much as 3300 points, clawing back to 18,600 levels. But investors who bought into that dead cat bounce must have sorely regretted their haste, as the Sensex promptly resumed its plunge and sank all the way to 8,600 levels by October that year. It took a good two years for the index to revisit the 18,000 mark after this fall.

While you are the midst of it, a dead cat bounce is indistinguishable from a real turnaround in the stock market. Most dead cat bounces become evident only in hindsight. Therefore, resist the temptation to bet your shirt on stocks the moment you see some green on your terminal. Buy a little and bide your time to see if the good times last.

The bottomline

Live cats are sweet pets, but dead ones can pack a nasty wallop.

A weekly column that puts the fun into learning.

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