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The Market Phenomenon You've Never Heard Of

It’s time to add another weapon to our investing arsenal. And it “pleasantly” involves reference to dead animals.***

Yes, it’s time for another conversation about crystal balls and market divination… the ever-skeptical value-investor anti-technicians out there on my distribution list can sit back and pipe down… I’ve heard all your ranting and complaints before.

One guy recently wrote to me:

“Enough with the hypocrisy. You rant about value investing like it’s the Holy Grail… you give us decent advice on good companies one minute, but the next you’re going on about the virtues of charting and technical indicators. You’ve even started throwing out crap about options at us. It’s nonsense. I’m starting to doubt your credibility as a serious investor.” - Reuben

Reuben, maybe you missed this one… as I wrote a long time ago… a successful investment strategy marries the concepts of Fundamental and Technical Indicators. And yes, even a healthy, measured dose of speculation is often warranted. If you need a refresher on what I’m talking about, see my classic essay “Wolves, Sheep, and Fistfuls of Dollars.”

With that laid to rest, let’s proceed to bare this wolf for all to see.

Both Wolves and Sheep Care About Cats

One of the recurring themes of my blog is ranting on people who call themselves investors, but are really speculators (market wolves). Anyone who invests money falls into the time horizon somewhere between a value investor (market sheep) and a speculator.

According to my irrevocable definition, a “value investor” places her money in an investment for a term of no less than five years. They look to collect dividends long-term, and reinvest them for maximum exponential returns in the long run.

A more active investor may place his money in the same investment as the value investor, but typically he won’t stay in it too long because he’s too antsy. He will hold a position anywhere from three months to a few years.

Finally, a speculator holds a position for an extremely short duration—it might be only a few hours, or it could be up to a few weeks. And he uses more volatile instruments to capture large, risky gains in short periods of time.

All of these investors, whether they will admit it or not, should care about "dead cats" in the market. Here’s what a bouncing dead cat looks like:

No, it’s not a grotesque picture of a dead animal dropped off a building. That would be disgusting and inhumane.

While you never, ever want to see a picture of a dead cat, you definitely want to know what a “dead cat bounce” looks like when it comes to stock charts.

Just about any solid object you drop from any height is going to bounce a bit once it hits the ground… even if the bounce isn’t very high. Cats are no exception. The term was coined in the 1980’s by a couple of journalists who recognized a significant bounce in the Singapore and Malaysian stock markets following a severe depression during this time and referred to it as a “dead cat bounce.” I guess the markets there are as skittish as cats.

A dead cat bounce helps us determine whether we are getting into an investment at the right time and the right price. Even if the company you are investing in has a good business, you won’t make any money if you are buying something that is overpriced, or if the stock price is set to decline further from where it is.

On the above chart, the market experienced a pronounced “dead cat bounce” in November-December 2008. The “bounce” refers to a sharp recovery in price following a severe or prolonged decline.

As you can see from the chart, the S&P cratered through the end of 2008, hitting a low of $741. Some investors saw this price as the market bottom amidst all the economic turmoil, and figured there would be a huge permanent rebound. And as you can see, many investors bought it... the market jumped 200 points within about a month... only to see the "cat" go racing towards the ground again at full speed.

The short-term investors who bought anywhere between $741 and $943, expecting things to go higher, got screwed. They had been too antsy for months to get back into the market. Those that jumped right into the market before seeing the cat bounce, then finally settle on the ground after the bounce, likely stayed "long" in the market.... and subsequently got creamed as things went ever lower than before to $666.

When we have severe, prolonged drops in the market, beware that you don't mistake "dead cat bounces" for genuine market recoveries. Typically after a severe decline, the market will rebound a bit, then fall again to at least the previous lows, many times lower, before carving out a permanent bottom, and paving the way for a prolonged uptrend.

I’ve beat your brains in about only buying into investments when prices low, or the odds are in your favor. When a good company experiences a decline—or a general market index, like the S&P 500—you’d be smart to watch for situations like this.

The dead cat bounce is a false “buy” signal… it typically happens after a sharp decline, where investors that are long the market begin piling in, anticipating that the market decline is over… they are often wrong, because they haven’t learned to ignore the bounce.

You must wait until the falling cat has hit the ground, bounced, then hit the ground again… this is typically the point at which the cat resurrects to rise at least above the height of the bounce.

Once the height of the "bounce" is broken, and prices are sustained above the bounce price, then we have a genuine buy signal. In the chart above, this uptrend was confirmed in June-July 2009.

Dead Cats Can Play Out in a Variety of Ways

A couple of further notes on this concept.

First, the bounce can play out differently depending on the type of investment you are looking at. If you’ve seen a decline in a major index or an industry-dominating business that has strong financials, and the decline in share price has accompanied a general market decline, it’s relatively safe to rely on the “dead cat bounce.”

On the flipside, if the company you are looking at is in a weak financial position and you have serious doubts about its ability to overcome this, the dead cat bounce may be no more than the result of speculators piling into a stock for the short term in hopes that others will join so they can sell and make a quick buck.

If you bought into a situation like this, you’re more than likely to get quickly hosed and soundly beaten.

I don’t trust the dead cat for anything other than blue-chip stocks or major indexes. As you can see, it would have helped you get good timing on the last five-year bull market. Getting in early on trends is key to maximizing your returns over time.

Using the dead cat bounce to try timing movements on lower quality companies can be like cutting loose a ravenous wolf on your innocent little portfolio. If a company is in bad shape, don’t use this indicator to signal times to buy.

In the end, the value investors are kind of right on this one—we’re trying with futility to time a market bottom by pulling out our crystal ball and predicting the future, which no one can really do. It involves risk, and the dead cat bounce can prove to be wrong, even for indexes or companies with fortress balance sheets.

But I think you’ll find this little gem to be a good addition to your timing techniques in the market. I know it has for me.

Live long and invest,

Jeremiah

***Although I don’t particularly like cats as household residents or otherwise, I don’t advocate cruelty to animals in any way, shape, or form, nor do I mock the way cats are hypothetically dropped from tall buildings in this manner.

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