Even dead cats can bounce back to life

WHEN things go disastrously wrong, the market is always ready to obliterate a stock. It could be because of mistakes made in a company’s operations, as in the case of Carnival earlier this year when one of its liners ran aground off Italy’s west coast. It could be like Facebook’s IPO, where the price rose on its debut offering, prior to hitting the floor and bouncing in early June, before resuming its journey southward. Or, as Standard Chartered shows, a company can feel the wrath of market bears after regulators express concerns about the company.

Whatever the reason for the decline, there is a certain macabre fun in watching a stock getting hammered. But when it’s all over, you may see a dead cat bounce in the stock’s price. Much like an expired moggy, even a seemingly demised stock will see a small bounce when it hits the floor.

Technical analysts describe a dead cat bounce as a continuation pattern that appears to be a reversal pattern. It begins with a downward move and is followed by a significant price retracement. The price falls again, exceeding the prior low.

Recently, citing the rebound of struggling BlackBerry producer, Research in Motion (RIM), UBS warned of the dangers of reading too much into the dead cat bounce. In a research note, UBS stated that the modest rebound in RIM’s stock price reflects increased optimism about potential M&A deals – the most recent rumour is that IBM has taken an interest in RIM’s network operations – as well as potential asset sales, cost cutting and partnership opportunities. The note stated: “Nevertheless, we see operating losses and no major catalysts over the next two quarters and remain on the side lines as we believe the company’s future likely hinges on a favourable BlackBerry 10 product launch early next year.”

The problem with dead cat bounces is that they tend to be observed in hindsight rather than spotted at the time. This isn’t to say that spotting a dead cat bounce is a waste of time (or cats). But traders shouldn’t be buyers just because they see a retracement. Traders should ask whether the move might be a temporary retracement before Tibbles heads back towards terra firma.

The physicist, Erwin Schrödinger, devised a famous thought experiment to show the uncertainty of matter uncovered by quantum mechanics (his cat was both dead and live at the same time). Like Schrödinger’s cat, traders sometimes have an equally tough decision in determining whether the company they are trading is dead or alive (or both).