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How not to get caught in a sucker rally

There are different kinds of sucker rallies in bear markets and they all call for caution, says this analyst. He carefully suggests three stocks.

W.C. Fields said: “Never give a sucker an even break.” He liked the phrase so much that he used it as the title for one of his movies.

Well in a sucker rally, there are precious few even breaks.

Sucker rallies are also called bull traps. By either name, they’re as old as the stock market. They put their seductive wares on display in every bear market.

And they are to be handled with care, says Mr. David Chapman. First, you have to recognize them, and they come in several different shapes.

This analyst examines the ins and outs of sucker rallies in Investor's Digest of Canada. In this environment, he suggests investors consider investments that have hit bottom and are on the road to recovery.

He suggests three. We’ll start with those three selections, then double back to make sure we’re not caught in a bull trap.

Bottoms up

In his shop, Union Securities, Mr. Chapman and his colleagues have noticed several sectors of the economy showing signs of bottoming out and getting ready to make their way back up.

Gold led the way out of the lows, and good signs have begun to appear for metals and mining. Other sectors are beginning to follow suit.

Now financial stocks, the bad boys of the credit crisis, are starting to look up. “Surprisingly, the ones that are signalling us to watch the sector are the insurance companies.”

The stock that gets the strongest recommendation is Sun Life Financial (TSX-SLF). This growing company spreads its insurance and investment business across Canada, the U.S. and Asia.

Also getting their attention is that temporarily wounded giant, Manulife Financial (TSX-MFC), whose wide reach includes insurance of every kind, pensions, annuities, mutual funds and wealth management.

The third is GreatWest Lifeco (TSX-GWO), which has life and health insurance, investment and retirement planning and reinsurance in Canada, the U.S. and Europe. It is under the powerful wing of Power Financial Corp.

But buy with care. Enter stop-loss bids to cushion yourself against a temperamental market, and consider selling after a 10 to 20 per cent profit, says this analyst. Here’s why.

Slammed in the teeth

There are little sucker rallies and there are big sucker rallies. The little ones may have a 10 per cent rise in a few weeks. The big ones can last much longer and push the market 50 to 100 per cent up from its lows.

“Little sucker rallies bring a wave of euphoria,” says Mr. Chapman. “Really big sucker rallies make everyone forget the previous drop, and then just when they believe it won’t happen again, they are slammed in the teeth.”

That doesn’t mean they’re a disaster for everybody, he adds. The short ones are good for “nimble traders,” while the long ones are fine for those “who possess a healthy skepticism and realize that this nice party will end badly.”

You can’t gauge a sucker rally just by looking at those arrows on the front page of the business section every morning. They can actually last for years, Mr. Chapman informs us.

In his view, the rising market of 2003 to 2007 was “a really big sucker.” While it surged ahead, those who warned about bubbles in housing, derivatives and hedge funds were scorned as pariahs.

Portfolio managers and many in the media kept cheering the rally on. Many of those same people now rationalize the collapse “and say that stocks are great value now and that you have to think long term.”

What sets off sucker rallies? Look for four key signs, says this analyst.

Investor fear gauge

“When sucker rallies start, “bearish sentiment is usually high and even at extremes,” explains Mr. Chapman.

The Chicago Board Options Exchange VIX indicator, which measures “implied volatility” (and is thus also known as the “investor fear gauge”), has usually reached a low. “The rally often starts as the market goes to new lows but the VIX does not.”

Economic numbers show signs of improvement, causing many to claim that the worst is over.

Stock valuations are low, leading many to tout the value in the market. (But remember, they can go lower still, the analyst warns.)

“When a rally does get under way,” this analyst points out, “many jump for fear they will miss the move, thus fuelling a further rally.”

When do these suckers end?

Stay skeptical

The first warning sign that a sucker rally is about to hit the wall comes with overconfidence in the market. Bullish sentiment rises, even though the economic numbers do not support it.

Trading volumes in the market are another critical sign. “The longer the rally goes on, the more are sucked back into the market, as the smart money is selling. Sucker rallies are usually on low volume.”

The rally ends suddenly as reality hits home, concludes the analyst, “usually resulting in a panic sell-off.”

This sucker rally took off from the March 6 low, Mr. Chapman tells his readers in Investor's Digest of Canada. Since then, the S&P/TSX Composite Index is up more than 20 per cent. He gives odds that it will take us to at least 10,400 and maybe as high as 11,300.

This would be advantageous to many investors, he adds, allowing them to restructure their portfolios and participate in the bull run. “Just remember to stay skeptical,” he cautions.

As the advance goes on, look for bullish declarations and volumes to perk up as more join the party. But volumes will still be lower than at peak levels as the smart money gets out.

That is why this analyst urges investors to use stop-losses and be prepared to take profits after a healthy gain.

In a word, if you don’t let yourself get played for a sucker, you can get an even break.