Dead Cat Bounce - Demand Reversal Following the Bursting of a Bubble

Abstract

This is the first paper to theoretically analyze the temporary reversal of the downward trend in financial assets, also known as dead cat bounce or bear market rally. We show that preferences according to cumulative prospect theory lead an investor to take ex- cessive risk and unprofitable positions in order to recover an initial loss in a declining market. The loss driven behavior results in premature re-entering into the market. We show that heterogeneous investors enter at the same time despite differences in the refer- ence point, wealth and initial loss. The resulting shift in aggregate demand can explain the sudden but temporary reversal common in declining financial markets.