Dead Cat Bounce?

"Even a dead cat will bounce if dropped from high enough." - An old trading saying

The dead cat bounce is a term used to describe a rally in a bear market.  After the market craters there is often a short term rally that can suck people into buying stocks thinking that the worst is over and that the market has finally reached the bottom.  Backing this up will be the talking heads on Wall Street and television to talk their book, encouraging people to buy stocks "on the cheap".  The focus of their discussion is normally on where the stocks were a few days or weeks ago and how a recovery is imminent.  (I can see them hanging their "buy now while cheap" signs out their windows now.)  There is never any discussion on where the stock could go if the bludgeoning continues and more often than not it is a lot lower than people can even imagine.  So let's take a look at the dead cat bounce and see if this is one of those events or not.

First off the market has not entered a formal bear market or even a correction yet.  A correction being a fall of 10% or more which while briefly touched during the trading session of the 25th did not stick as the market rallied sharply from that level and closed well off the lows.  As we are not formally in a correction there is a chance that the bounce is sustainable as the sell off could be just that, a sell off caused by the China rout and we are back to business as normal.

The next two thing to look at are the magnitude and age of the sell off.  While relatively deep the sell off still did not enter a correction so by this metric it may be more than a bounce. Considering the short period of a week it is very young and therefore has not established itself as a longer term bear market.  As the "correction" (assuming that is what we are witnessing) is an infant there is a good chance that the market has legs and can do more than just bounce from here but can somehow spring back to life.

A fourth thing to consider is which stocks were responsible for the recovery rally.  Looking across the board it appears that it was a short covering rally as stocks like Arch Coal gained 33% while Google only gained 3%.  The former has a very concentrated short interest (sellers that have no stock in the company and are betting that the price will fall) while the latter has very little short interest.  Short covering is considered a key ingredient to dead cat bounces as they are not true buyers of the stocks but are just covering their trades to lock in profits.  Once their covering ends the market resumes its previous trend so this metric checks the box of a dead cat bounce.

The final thing to consider is the underlying fundamentals of the market.  With the long unchecked upward trend well overdue for a correction, stock price valuations way above normal, China's economy cratering before our eyes, Europe and Japan weak and the Federal Reserve up against the wall it looks very much to me like the dead cat bounce wins the day.

Regardless of whether I am right or wrong on my prediction you should ask yourself, based on the week's massive volatility is this a market that I really want to play in and if you do is it a speculative investment or something that you truly believe in?  My guess is that anyone that is willing to buy stocks here is gambling with their investment dollars and that is a sure way to the poor farm unless you are a seasoned professional in which case you would be short the market.