How to Spot a Sucker Rally

Investors are constantly looking for catalysts to drive stock prices higher — a particularly tough task in this dismal market. But on Tuesday investors found one, albeit a flimsy one at that. A leaked memo from Citigroup (C) Chief Executive Officer Vikram Pandit said the beleaguered financial services giant had been profitable during the first two months of 2009. Stocks instantly took off on the news. The Dow Jones Industrial Average surged 379 points, or 6%, the 19th largest single day increase in its history.

But as much as that rally was welcomed, it now leaves investors in a bit of a conundrum. If, indeed, Citi is about to record a quarterly profit does it mark a bottom for the financial services industry that has dragged down stocks the last year? Or is this just a classic bear market rally that will dissipate as quickly as it came along? Investors who answer those questions wrong can wind up losing a lot of money.

A bear market rally — or what we call a suckers’ rally — often appears during downturns as the market tries to get back on track. History tells us stocks don’t bottom out on a single day; it’s a lengthy process. And they also don’t recover along a smooth, upward trajectory. So during some sessions stocks can record a big gain. But they are just as likely to fall right back down the next day or week. Blame it on short squeezes or liquidations or, in the case of Citi, desperate traders seeing a silver lining in the thinnest of corporate news.

Tuesday’s rally appears to be something of an anomaly. Indeed, on Wednesday the market struggled to stay even through afternoon trading and even showed signs of heading into the red. And therein lies the problem: Opportunistic investors jump into a rally well after it has started and promptly see their positions fall right back down to earth the next morning. “I think there’s a bear market rally going on,” says Doug Roberts, chief investment strategist at Channel Capital Research, a Shrewsbury, N.J. investment firm. “The banking system is fundamentally unstable. This rally is being triggered by banking rumors, positive comments by Bernanke and the uptick rule.”

However, after months of this up-and-down volatility there are some market watchers who believe we may be on the upswing. Robert Brusca, founder of Fact and Opinion Research, thinks the suckers are investors who are still holding back. “I think it’s real; I think it’s about due,” he says of the market pop. “I think there are signs in the economy that should cause [investors] to believe in a rally in the stock market.” To back up his argument Brusca points to positives like recently announced merger between Merck (MRK) and Schering-Plough (SGP) and job loss figures that seem to be leveling off since December.“First we lose jobs, then the losses stabilize, then we move to gains – that’s how you move to recovery,” he says.

Unfortunately, only time will tell us which expert is correct. Indeed, smart investors continue to build a diversified portfolio during downturns instead of trying to play market bounces. Bill Stone, chief market strategist at PNC Wealth Management, agrees. “Sentiment is so bad right now that it will take very little to give the market a pop,” he says. “And once everyone has piled on to one side, it takes very little to change that balance.”