Don’t Get Fooled By A ‘Dead Cat Bounce’

bull and bear market

Value investors pride themselves on being able to identify out-of-favor or misunderstood stocks and take advantage of its price difference relative to its intrinsic value. Oftentimes, this means buying a stock near a 52-week low or after a sustained drop in price. But timing is everything – buy too late and you’ve missed out on the rebound, buy too soon and you could lose money or be forced to wait longer than anticipated.

Value investors can get fooled into buying too early if a stock begins to climb after a recent fall. In an effort to hop on board before the stock completely recovers, value investors may be tempted to buy as soon as a stock shows positive gains again. But all too often these stock recoveries are only temporary and value investors that jump the gun are left with a falling stock price and an unknown recovery time.

The market is a trickster

The stock market may behave in certain patterns, but it’s not always easy to see what those patterns are and what path the market will take before a cycle can be observed. Corrections are a normal part of the market’s life-cycle as are long periods of sustained gains. Bear markets can creep up unexpectedly as well making it challenging to accurately predict when a correction is just part of a normal bull market or the beginning of a bearish reversal.

One of the biggest illusions in the market is the ‘dead cat bounce.’ This is when a stock shows positive gains after a recent decline but quickly sheds those gains to resume its downward momentum. Many investors have fallen into this trap only to realize too late that they’ve bought into a false premise of recovery.

Investors worried about getting caught in a ‘dead cat bounce’ need to look for the signs that a recovery may be just an illusion. One of the most common reasons for the temporary spike in value after a decline is short covering activity. Investors that bet against the stock by selling it short need to buy back their shares in order to close out their positions. This buying activity can boost the price of the stock for a limited time before the underlying fundamentals that contributed to the original decline take over again.

The key to avoiding the ‘dead cat bounce’ trap is sticking to your initial analysis of the stock. Stock prices move up and down for a number of reasons, many of which have nothing to do with the actual value of the underlying company. If you see a possible value play and understand at what price the stock should be purchased, then you shouldn’t be tempted to buy before the stock hits that level.

Final thoughts

Patience is one of the hardest things to learn as an investor. A stock on a value investors watchlist that suddenly starts to reverse course can send the message that ‘it’s now or never.’ One of the most repeated phrases on Wall Street is that “no one makes money by panicking.” Trust the fundamentals and don’t let other investors fool you into making a mistake.