By Samuel Taube
“Buy the dip” is one of the mantras of contrarian investing. You can make a fortune by picking up cheap shares in a downtrodden company and waiting for it to recover.
But this strategy can be risky. When a stock is declining, there’s no guarantee that it’s going to recover at all. And even if it goes to zero, investors may be lulled into a false sense of hope near the end.
That’s because many failing stocks experience a short-lived recovery just before their demise, popularly known as a “dead cat bounce.” Below is a graph of Blockbuster. You can see a few dead cat bounces in the late 2000s, shortly before the company’s Chapter 11 filing in 2010.
This morbidly named phenomenon is a natural result of market forces taking hold as a company goes under. And it can put an inexperienced investor in a very bad spot. Below, we’re looking at why dead cat bounces happen – and how to tell them apart from actual recoveries.
Why Dead Cat Bounces Happen
When a stock is circling the drain, traders tend to short it a lot. And as you may recall from our explainer article on shorting, the process involves two steps.
In the first step, a trader borrows shares in the company and sells them at their present market value. However, they eventually have to buy back and return those borrowed shares, as they’ve sold something they didn’t own. The trader is hoping to repurchase and return those shares at a lower price than the original sale.
Obviously, a stock’s price falls when sold and rallies when bought. As a result, when closing a short position, a trader might actually cause a brief uptrend in that stock. If a bunch of traders repurchase their short-sold shares at the same time, they can cause a large, but brief, rally. This is how most dead cat bounces happen.
Dead cat bounces may also result from errors in technical or fundamental analysis. A fast-dropping stock may deceptively appear to give off certain “buy signals” as it heads toward zero.
For example, a failing company may appear to have a low P/E ratio and a stock price trajectory that shows a “trend reversal” pattern. Out of context, both of these signals are good things for a stock. But they can also happen naturally as a business nears the end of its life.
Thus, a trading algorithm (or a very dopey human trader) may be fooled into thinking that a stock is rallying just before it goes under. And if they’re unlucky, they may act on this idea and buy some shares, thus contributing to a dead cat bounce.
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How to Spot a Dead Cat Bounce
We’ve just identified two major causes of these brief faux recoveries: short closing and analyst error. Fortunately, both of these behaviors leave telltale signatures in market data.
One publicly available piece of information about any stock is the short interest. Shorting involves borrowing shares and paying them back with interest. And interest rates are determined based on risk of …read more
Source:: Investment You
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