As the stock market reverses trend from positive to negative, let's look at one of the biggest trap during the bear cycle in the market.
trend reversals
After long and continuous bull phase markets become overbought, expensive and enter a bubble phase and for one reason or another has to correct to get rid of the excesses. After all underlying business does not grow on a daily basis but the market can run up daily leading to divergence between fundamentals and market value. So once the market reaches the tipping point it reverses trend and starts falling instead of rising.
dead cat bounce
As markets fall sharply they pause in between and give minor bounce backs periodically just like they correct periodically with minor falls during a sharp rise. This is known as dead cat bounce. It means market is like a falling dead cat that bounces after hitting the ground but is nonetheless still dead. When first wave of sell-off is over market bounces a bit as it hits technical support levels and then resumes it's fall again. Instead of falling straight from top to bottom, it is more like a dead cat falling through the stairs and bouncing everytime it hits the floor of the stairs at each step. So whenever there is a trend reversal followed by a sharp fall, expect a series of similar pattern to occur post the major event.
the bounce trap
Novice investors look at this bounce and think that the fall in the stock market is over and now it will start rising again like it was doing before the fall started. So they pounce on the first bounce back thinking that they are getting the stocks much cheaper compared to the recent highs. What actually happens is that the bears are just taking a break and the technical bulls are just trying to play for small gains from a bounce at the support levels. This bounce sucks in many new and inexperienced investors, as bulls and bears play their game in the market. The bounce back actually gives a slightly better price for the bears to start the next wave of shorting. Simply put the bounce back gives the market more momentum for the next fall. This pattern continues till the market reaches the bottom of the stairs and gets so cheap that the battered fundamental bulls can buy huge volumes of stocks with very little investment i.e the stocks have become ridiculously cheap. One example in such cases could be stocks offering better dividend yields than fixed deposit interest rate. This helps the bulls make a fully charged comeback and reverse the trend from negative to positive again.
Also note that initially as the trend changes to negative many bulls get stuck and run out of cash. It takes some time for them to recover from shock & surprise and arrange for enough ammunition to fight back the selling pressure from the bears. So after a major event almost certainly you should not expect an immediate reversal within a few days. It takes some time. Any rally immediately after major falls is most likely a counter trend pull back that is not guaranteed to last. It will take multiple waves of similar events and enough consolidation time for the larger trend to reverse again.
lessons from the bouncy cat
The main goal of the article is to help you understand the risks and the pitfalls that lie in the small counter-trend rallies within a major trend. You should be skilled enough to recognize these and not get sucked in by it. Let the dead cat fall, bounce, fly, do whatever it likes, don't pounce on it, just focus on the larger trend & fundamentals.
trend reversals
After long and continuous bull phase markets become overbought, expensive and enter a bubble phase and for one reason or another has to correct to get rid of the excesses. After all underlying business does not grow on a daily basis but the market can run up daily leading to divergence between fundamentals and market value. So once the market reaches the tipping point it reverses trend and starts falling instead of rising.
dead cat bounce
As markets fall sharply they pause in between and give minor bounce backs periodically just like they correct periodically with minor falls during a sharp rise. This is known as dead cat bounce. It means market is like a falling dead cat that bounces after hitting the ground but is nonetheless still dead. When first wave of sell-off is over market bounces a bit as it hits technical support levels and then resumes it's fall again. Instead of falling straight from top to bottom, it is more like a dead cat falling through the stairs and bouncing everytime it hits the floor of the stairs at each step. So whenever there is a trend reversal followed by a sharp fall, expect a series of similar pattern to occur post the major event.
the bounce trap
Novice investors look at this bounce and think that the fall in the stock market is over and now it will start rising again like it was doing before the fall started. So they pounce on the first bounce back thinking that they are getting the stocks much cheaper compared to the recent highs. What actually happens is that the bears are just taking a break and the technical bulls are just trying to play for small gains from a bounce at the support levels. This bounce sucks in many new and inexperienced investors, as bulls and bears play their game in the market. The bounce back actually gives a slightly better price for the bears to start the next wave of shorting. Simply put the bounce back gives the market more momentum for the next fall. This pattern continues till the market reaches the bottom of the stairs and gets so cheap that the battered fundamental bulls can buy huge volumes of stocks with very little investment i.e the stocks have become ridiculously cheap. One example in such cases could be stocks offering better dividend yields than fixed deposit interest rate. This helps the bulls make a fully charged comeback and reverse the trend from negative to positive again.
Also note that initially as the trend changes to negative many bulls get stuck and run out of cash. It takes some time for them to recover from shock & surprise and arrange for enough ammunition to fight back the selling pressure from the bears. So after a major event almost certainly you should not expect an immediate reversal within a few days. It takes some time. Any rally immediately after major falls is most likely a counter trend pull back that is not guaranteed to last. It will take multiple waves of similar events and enough consolidation time for the larger trend to reverse again.
lessons from the bouncy cat
The main goal of the article is to help you understand the risks and the pitfalls that lie in the small counter-trend rallies within a major trend. You should be skilled enough to recognize these and not get sucked in by it. Let the dead cat fall, bounce, fly, do whatever it likes, don't pounce on it, just focus on the larger trend & fundamentals.
No comments:
Post a Comment