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Dead Cat Bounce in Crypto

October 25, 2022 - 7 min read

The term “dead cat bounce” refers to a phenomenon in the financial world that occurs when the price of an asset that has been steadily falling increases in value for a short period before continuing its downward trend.

The proverb “even a dead cat will bounce if dropped from high enough” is where the name “dead cat bounce” comes from. A dead cat bounce occurs when asset prices experience a temporary increase after experiencing a consistent downward trend. This rise in stock prices indicates a false reversal or an upward movement in the market. Then, the price drops to a new low after some time, thereby maintaining the downward trend.

Using a combination of technical and fundamental research, analysts may forecast that the rebound would be short-lived by using particular analysis techniques. For example, it is possible to observe a dead cat bounce in the economy as a whole, such as when it is in the depths of a recession, or it is possible to observe it in the price of an individual equity or an entire asset class.

When determining if a falling equity’s unexpected upward rise represents a proper recovery or a DCB, technical indicators, experience, and time play an essential role in the determination. It all depends on whether any price recovery represents a trend reversal or not.

If the closing price of an equity is lower than the opening price by at least 5 percent, this may indicate that a DCB has occurred. Even in the case of equities that are prone to volatility, the drop typically needs to be greater than 5%.

Why is it Called a Dead Cat Bounce?

The common use of the phrase arose from within the United Kingdom in the early 1980s amid economic turmoil. In December 1985, Horace Brag and Wong Sulong of the Financial Times coined the term to describe the rebound of the Singaporean and Malaysian stock markets following sharp declines. Unfortunately, the economies of both nations continued to collapse and did not recover until much later.

What Does a Dead Cat Bounce Indicate?

The purpose of attempting to identify a dead cat bounce is to discover if a stock or other asset that gains value after a prolonged slump will continue to rise in price. For example, if a trader has sold a stock short and considers a succeeding price increase as a dead cat bounce, they might elect to keep the short position. If, on the other hand, a trader perceives a price movement to be a durable rally, they should close the short position.

Dead cat bounces are typically noted in retrospect, as analysts and traders need help to identify a simple trend reversal. However, the majority of the time, such a surge can be attributed to bargain-hunting traders and investors who may misjudge the stock price’s bottom.

Typically, the opportunity is advantageous for short-term traders, as it allows them to profit from the quick rally. Additionally, investors might utilize the incident to initiate short positions on the security.

Examples of Dead Cat Bounce

The Dow Jones Index’s Dead Cat Bounce in 2008

The Dow Jones Industrial Average (DJIA) is an indicator used in the stock market that measures the performance of 30 sizable, publicly traded businesses listed on the NASDAQ and the New York Stock Exchange. The worldwide financial crisis of 2008, brought on by the collapse of the housing market and the subprime mortgage sector, resulted in a major decline in the DJIA.

The DJIA underwent several brief recoveries during this period, known as dead cat bounces, as investors waited for the market to turn around. For instance, the DJIA rose in the middle of 2008. However, these recoveries ultimately fizzled out, and the DJIA kept declining. In March 2009, the market finally hit bottom, and since then, it has dramatically rebounded.

LUNA Crisis

The cryptocurrency known as LUNA, as well as its stablecoin UST, lost nearly all of its value in a relatively short period of time. The failure of the LUNA coin will go down in history as one of the most significant events ever occurring in the cryptocurrency space. The collapse of LUNA sent shock waves through the market as a whole and created concern among retail and institutional investors.

It is evident that the LUNA chart experienced multiple fleeting recoveries that resulted in dead cat bounces (specifically May 8-9 in the above chart).

How to Spot a Dead Cat Bounce

Although a dead cat bounce is challenging to identify in real-time pricing, it is possible to identify one using historical data. For instance, when a bear market follows a prolonged bull market, there could be instances of temporary rises in prices during a bear market, but it is unlikely that higher prices will be maintained.

There are three stages involved in the process of a dead cat bounce: 

  • The price of any asset decreases dramatically over time.
  • The asset’s price then experiences an abrupt surge, which may give the impression that the decreasing trend has been reversed.
  • Finally, the price that had been climbing begins to fall again, falling to newer lows and continuing to follow a downward trend.

Examining the market’s fundamentals is one method that can be used to identify a dead cat bounce. For instance, market conditions could be considered bearish after certain companies’ shares dropped by at least 20 percent from their peaks during the first half of 2022. However, there have been several periods characterized by brief recoveries of 5 percent or more before collapsing to new lows. This happened in January, March, May, June, and again in September with the S&P 500, for example. Some could argue that the current recovery we have witnessed since October is another DCB in the making. 

A Dead Cat Bounce in Crypto Markets

The unregulated structure of the cryptocurrency market and the speculative price movement has made the cryptocurrency market highly unpredictable. This has resulted in multiple instances of dead cat bounce in the past. For example, due to the initial coin offering (ICO) bubble in 2017, the price of Bitcoin skyrocketed to an all-time high value of $20,000.

Bitcoin’s price dropped from about $30,000 to nearly $3,000 in the wake of the bubble bursting, although the price drop was inconsistent. The inflated value of Bitcoin bounced like a dead cat a significant number of times along its downhill route.

It’s possible that some people were surprised by Bitcoin’s subsequent comeback and swift ascent to its newest all-time high of over $50,000 this year. This is especially likely considering Bitcoin’s response to the initial coin offerings (ICOs) surge in 2017. However, this does demonstrate how inflated the Bitcoin bubble had become, which caused investors to sell up their holdings as soon as they understood what was happening.

In June 2022, the price of Ethereum plunged to $880 due to a big sell-off on the cryptocurrency exchanges. Most cryptocurrencies, including Bitcoin, have reached new 52-week lows. The persistent bear market in traditional markets, especially in tech equities, has a ripple effect on the cryptocurrency markets. While many analysts fear that the worst is yet to come for cryptocurrencies, many others share this sentiment. Consequently, any optimistic Ethereum price forecasts appear to be precarious.

The price of Ethereum was $1040, a decrease from its all-time high in November 2021, when it reached a price of $1,500. Even if ETH is up 24 percent from last week’s lows, many investors view the latest rebound as a dead cat bounce.

It is vital to highlight that a dead cat bounce is caused by a deteriorating trend, not the other way around. Therefore, the appearance of a dead cat bounce does not automatically portend doomsday. Occasionally, the cause of the current decline can resolve itself, resulting in the asset’s return to a bull market.

How Long Does a Dead Cat Bounce Last?

In addition, the duration of a dead cat bounce is flexible, and it is also impossible to correctly forecast how long it will last. For example, it may only last a few days or continue for several months at a time. This unpredictable nature makes it difficult and time-consuming to accurately detect a dead cat bounce as it happens.

Limitations in Identifying a Dead Cat Bounce

As mentioned earlier, the most challenging aspect of detecting a dead cat bounce is that it can only do so in a reliable manner after it has taken place. As an illustration, after the S&P 500 (S&P INDEX: GSPC) had a significant drop in March 2020 as a direct result of the pandemic and then began to turn around, many market observers at first mistook the subsequent rise for a “dead cat bounce.” However, because of the significant rise in the value of the S&P 500 index since that time, it is abundantly evident that those analysts were incorrect when viewed through the lens of hindsight.

If the technical stock analysis were consistently accurate, investing money in the stock market would be a simple way to amass wealth. However, this is not the case.

References

  1. (2022, 22 Jun.). Ethereum: Recovery or dead cat bounce? Either way, Chronoly rises 500%. Coinpedia.
  2. Daniele, D. (2021, 12 Jul.). How to spot a ‘Dead cat bounce’ (+ strategies to trade it). Day Trade The World™
  3. Jafar, B. (2022, 13 May). Crypto market: Sustainable rally or dead cat bounce?Finance Magnates
  4. Levy, A. (2022, 29 Jun.). What Is a Dead Cat Bounce in Investing?The Motley Fool.

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