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3 Tell Tale Signs Of A Sucker Rally
Friday December 5, 3:31 pm ET
By Simon Maierhofer

As of late, there's been much talk about the Great Depression. From September 1929 to June 1932 the Dow Jones (AMEX: DIA - News) lost 90% of its value. Obviously this wasn't a good time to be invested or stay invested.

Along this long and painful road down to Dow Jones 45 (the Dow dropped from 380 to 45) there were at least five counter trend rallies with moves of 20% or greater. In fact, the biggest point gains (in percentage terms) occured in sucker rallies. (see chart below).

Those counter trend rallies were often accompanied by increased volume indicating that investors jumped on the band wagon believing that the worst was over. In hindsight we know that the worst wasn't over until it was over, which was when no one wanted to own stocks anymore. Volume in June of 1932 was anemic and continued subdued until the Dow was able to reach a new high in 1954.

For good reason, counter trend rallies are also lovingly called 'sucker rallies' or 'dead cat bounces', both of which are self explanatory. Sucker rallies are fueled by investor's fear of losing out on an opportunity to make money. This force is not strong enough to propel a market for long and is eventually taken over by the fear of losing money which drives prices to yet another lower low.

Needless to say, the ability to distinguish a sucker rally - even the mere awareness of the existence of sucker rallies - can save you a lot of sleep and a ton of money. The benefit of spotting a dead cat bounce is two-fold. It can give you a better exit point and can prevent you from getting sucked into further losses.

How to spot a sucker rally: 1) Think like a contrarian:

Rallies occurring amidst hope and entitlement for more gains are doomed to fail. For example: Less than three months ago a headline on Smart Money Magazine's front page read: 'Now is the time to jump into stocks and real estate'. Since the headline, the S&P (AMEX: SPY - News) and Vanguard Total Stock Market ETF (NYSEarca: VTI - News) dropped over 30%. One of yesterday's headlines touted, 'Yes, stocks are dirt cheap'.

On August 8, 2008, USA Today featured the following headline: 'On Wall Street, there is no such thing as a sure thing. But betting on a stock rally when oil prices plunge 20% comes pretty close'. Oil prices did plunge, the United States Oil Fund (AMEX: USO - News) shed 70%. There was however no rally for stocks to be found. Broader commodity ETFs like PowerShares Commodity Tracking (NYSEarca: DBC - News) and iShares S&P GSCI (NYSEarca: GSP - News) took significant hits.

When oil was $147/barrel, analysts projected $200/barrel. Instead oil took the route less traveled, now trading at below $50. Costco and Wal-Mart's move to restrict the sale of rice sparked talks about a global food shortage. The price of wheat, corn, rice and soybeans has been in a steep decline ever since. The PowerShares Agriculture ETF (NYSEarca: DBA - News) reflects the pain of agriculture commodity bulls (or should we say suckers).

How to spot a sucker rally: 2) Take a look at the bigger picture:

The fear of missing out on the next big opportunity often keeps us from taking a step back to look at the bigger picture. We are in a confirmed down market. Even the U.S. government officially admitted that we are in a recession and 60% of Americans believe we will tumble into a depression. Let's face it, nobody wants to own stocks. If you don't believe me, take a look at the chart. Dow down means investors are selling.

We are conditioned to believe that the next bull market is just around the corner. A bull market in Nasdaq (Nasdaq: QQQQ - News) technology stocks was followed by a bull market in real estate which was followed by a bull market in commodities. But we've run out of bulls. We are in a buyer's market, and the smart money is waiting to buy at lower prices.

How to spot a sucker rally: 3) Look at who's greedy:

Baron Rothschild is famous for coining the saying: 'The time to buy is when blood is running in the streets' or as Warren Buffett puts it, 'the time to be greedy is when others are fearful'. No bottom is in place as long as the average investor displays a buy-and hold sentimentality. Buy-and hold indicates that there is enough hope and greed to win back what's been lost.

This mentality won't get you back the 55% you've lost in your iShares Emerging Markets Fund (NYSEarca: EEM - News) or the 50% you've lost in your diversified, global iShares MSCI EAFE (NYSEarca: EFA - News). A sucker rally may give you back some 20%, but then it's time to get out and keep your powder dry. Long is wrong.

Weeks in advance, we warned of the financial meltdown, in fact, over six weeks ago we alerted members of the ETF Profit Strategy Newsletter that the Dow will have to drop below 7,500 before bottoming. The major market indexes have rallied 15% since their November low. Nevertheless, I am concerned.

The last two up-days came on the heels of waning volume and weak breadth which has us worried yet again. In yesterdays update we highlighted a short ETF strategy which should be implemented if the Dow and S&P 500 don't reach our upper end 'control levels'. In a market like this, an investment in knowledge pays the best dividends.