What Is The Difference Between An Exhaustion Gap And A Dead Cat Bounce?

The S&P and Dow pulled back today as volume came in light.  The NASDAQ was barely positive.  Last week’s rally was fairly impressive based on a couple of things.  First of all price gains were solid across the board.  Secondly, these price increases occurred while oil prices also rose.  Until last week, every little rise in the price of oil seemed to spook the market. 

So why aren’t I getting more excited?

The S&P has been chopping lower for over six months.  The NASDAQ even longer.  When the market undergoes an intermediate-term correction like we’ve seen, it is unusual to see it bottom without some degree of capitulation.  Typical capitulation was not evident near the 8/13 lows.  Secondly, the initial bounce off those lows should show some strong conviction.  Rapid price gains.  High volume.  Everyone rushing in because they don’t want to miss the bottom.  I’ve seen no such action.  Lastly, there is a ton of resistance still above us.  Even if the S&P makes it through the much talked about resistance around 1108, it still has 8 months of congestion to deal with.  I still believe we’re going lower.  Of course, I’ve been wrong before.

After my article about dead cat bounces on Wednesday, I received several emails asking the same question (if you didn’t get a reply, it’s because your email bounced back to me):

"If a stock is already in an extended downtrend, how can you tell the difference between an exhaustion gap and a dead cat bounce?"

The short answer is this – I can’t.  Not until I see if it rolls over or continues higher (and that’s cheating). 

Stocks that aren’t already in extended downtrends have a higher probability of not encountering this problem.  Still, even stocks in extended downtrends have a tendency to continue lower after a big drop. 

You may want to check the news that caused the stock to drop.  Many events could cause an overreaction and exhaustion gap.  If it’s fraud related on the other hand, then it may just be the tip of the iceberg.  For an example of this, take a look at a Tyco (TYC) chart from 2002.  Bad news led to more bad news and it was one big drop after another.  Even better known examples would be MCI or Enron.

Best of luck with your trading,

Rob

robhanna@comcast.net