What is a ‘dead cat bounce’ and is the ASX 200 in one right now?

What’s next in store for the large end of the market?

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Cat jumping from a sofa, symbolising dead cat bounce.

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Key points

  • Many experts are postulating on the market's next moves 
  • Some argue we might be in the midst of a dead cat bounce, a chart pattern seen in a bearish market 
  • ASX large caps have staged a comeback rally in the past few weeks as the US Fed gives more clarity on the federal funds rate 

The benchmark S&P/ASX 200 Index (ASX: XJO) is gaining strength this week and is now trading up more than 1.25% in the green at 7,369 points.

After plunging to a low of 6,838 points back in late January, the ASX had staged a remarkable rally before then being rejected at the 7,200 points mark in mid-Feb.

ASX large caps then took a nosedive and tumbled in a tight range for the remaining days of the month.

However, as more clarity around the inflation and interest rate narrative has emerged, market pundits are now jumping behind ASX large caps once more.

But could this just be a fake out that is the result of a classic chart pattern better known as a ‘dead cat bounce’? Let’s take a look and see what the experts think.

What is a dead cat bounce?

A dead cat bounce is a term traders, market pundits and those on Wall Street use to describe an unfamiliar bearish chart pattern on the price of a particular stock.

The phrase stems from the old adage that even a dead cat will bounce if it falls hard and fast enough, a tribute to some of the famous stock market cases of times gone by.

It’s seen on the chart as a short-lived recovery in the price of a stock that has been declining – usually at a fairly rapid pace, Bloomberg notes.

Due to the force at which the price is hammered down, often this leads to a temporary reversal, where the price might charge up again.

However, as both market and company fundamentals begin to weigh in, the downward pressure mounted is often too much and the longer-term, downward trend soon continues.

It would be as if you traced the path of a dead-rubber ball that was dropped from a height – it would fall, bounce, and then once the downward force equalises, hit the floor again.

That’s not unlike what we see on the chart pattern of a dead cat bounce, although it’s something that is recognised in retrospect – so not really a trading or investing tool.

Is the ASX in one?

Recently, Kyle Rodda, market analyst at IG Markets, noted that the ASX could have been in a dead cat bounce in early January as the index bottomed.

He said that price action at the time had “commentators asking whether the bottom was in. [The] price action seems to suggest it could just be a dead cat bounce.”

That was in late January, and by all accounts – the market did bounce from its low, recover, and then recede further downwards.

“At the moment, either [situation] could be true because it won’t be until some clarity is given by the Fed about its policy intentions that markets may settle down,” he added.

TradingView Chart

Well, the Fed was clear on its policy move in its most recent meeting. From 2022, the US will opt to raise both the federal funds rate and the terminal rate for the first time in years, meaning interest rates are set to rise in the US. It is looking to raise a number of times in 2022, unless inflation starts to creep back down.

And the market’s reaction has been clearly positive, and some experts, like JP Morgan’s Marko Kolanovic, suggest that a rotation back into beaten-down tech stocks is warranted.

That suggests a bullish outlook for the long-term, seeing as the valuations on growth/tech shares are based on cash flow projections long into the future.

Given the fact that a dead cat bounce is typically a pattern seen in hindsight, it remains to be seen if the ASX is currently in the midst of the pattern performing.

What is true is that price action is supportive of the current gains and that overall, the index appears to back towards its 3-month highs.

Motley Fool contributor Zach Bristow has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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