Dead Cat Bounce or Another Market Bottom?
Updated: Jul 23, 2021
Stocks rallied sharply higher on Tuesday, rebounding from one of the worst trading sessions since last October. After rising at the opening, the rally picked up momentum into the end of the day. The Dow Jones Industrial (INDU) gained 1.62% or 549.95 points of the 726-point loss from Monday, marking one of the best trading days of the month. The S&P 500 Index (SPX) also rallied 1.52% or 64.57 points, and the technology-laden Nasdaq Composite Index (COMPQ) finished 1.57% higher or 223.89 points, recording one of its best gains since the May timeframe.
The National Bureau of Economic Research (NBER) made it official yesterday - the pandemic sparked recession ended in April 2020 after just two months of economic contraction. That makes the two-month downturn the shortest recession in U.S. history, nearly 4-months shorter than the Jan 1980-July 1980 recession.
Most blamed the recent selling on the rising Covid-19 cases, specifically the spread of the more infectious Delta variant. Reopening sectors took the brunt of the sell-off on Monday, as investors feared a third phase to the Covid-19 pandemic and its impact on the recovering global economy. Although the economy has recovered from last Spring 2020, many investors are still wary of the recovery peaking, rising inflation, and falling U.S. interest rates. Also, we are in the middle of the second-quarter earnings season and summer doldrums. Despite the above concerns, stocks remain near their all-time highs, as all three major indexes set record highs last week.
Is the low yesterday a dead cat bounce or a sustainable bottom?
The name "dead cat bounce" refers to the concept that even a dead cat will bounce if its falls far enough and fast enough. A dead cat bounce is often a temporary, short-lived but sharp rebound after a sudden or prolonged period of decline. Only to be followed by the continuation of the downturn.
There are many reasons for the dead cat bounce, including short-covering, bottom fishing, value investors, oversold condition, among others. The length of the bounce can vary greatly – anywhere from a few days to several months. It depends on various factors such as the magnitude of the decline, speed, and severity of the sell-off.
It is difficult to determine whether the recovery is a dead cat bounce or a key market reversal as market bottoms are often difficult to predict. A market bottom occurs after the fact. It takes time to develop and evolve. Although it may sound simplistic, stocks bottom when there are few sellers or when the selling is exhausted. When few sellers are remaining, and buyers return then this hints at the start of a bottoming process.
How do you know if a market is indeed bottoming?
Look for an increase in volume on rallies. Expansion in market breadth and broader market participation are signs of a bottom. Recovery above pivotal technical levels, including prior supports, moving average, breakdown levels, reaction highs, etc. are constructive. Supply and demand equilibrium level shifts back to favor the buyers, as evidenced by a higher-low and eventually a higher-high pattern. At the very least, look for sideways technical basing efforts rather than lower-lows. After a sharp sell-off, a bullish follow-through day denotes technical strength, like key reversal patterns such as gap-up, island reversal, positive outside day, etc. are also good signs of a market bottom.
During a market downturn, many traders and investors will attempt to catch a market bottom – but it is better to err on the side of caution as most trades will end in failure or frustration. Unless it is a V-type recovery, it will likely take days and even weeks to confirm a sustainable bottom. As noted above, a market bottom is a process. Reclaiming previous key technical breakdown levels, retracements, and moving averages are often the first steps to confirming a sustainable bottom. Higher-lows are also technically constructive as this indicates a shift toward more buyers than sellers. To avoid a dead cat bounce, bottoms will take time to develop, and having the above technical signs in place can increase the odds of a favorable market outcome.
Enclosed is a short-term chart of SPX. Pay close attention to the technical levels in the next few days or weeks to either confirm a dead cat bounce or a sustainable market bottom.