Stocks: Beware the Sucker's Rally

Have equities finally hit bottom, or is the market's recent rebound a trap for overeager investors?
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After a tough winter for the stock market, some signs of spring are appearing.

The broad Standard & Poor's 500-stock index jumped 5.12% from Mar. 18 to Mar. 25, while the battered financial sector has done even better. The Financial Select Sector SPDR (XLF) exchange-traded fund has surged 11% in the past five days.

Both measures are down almost 8% since the New Year, with the Financial SPDR down a whopping 21.7% in the past six months and the S&P 500 off 10.8%. But that just points to how welcome this recent rally is for depressed and anxious investors.

The U.S. economy's slowdown and the financial crisis have battered stocks for months, but some market observers are now wondering if an end is in sight. Perhaps, with the recent collapse and bargain-basement buyout of Bear Stearns (BSC), stocks have hit bottom and investors can begin to put the bear market of 2008 behind them.

Not so fast, market experts say. Yes, there's a chance the worst is behind us, but there's an equal or better possibility the stock market is experiencing a classic "bear market rally," they say.

Levels of Pessimism

The stock market is like a sprinter, says Chris Johnson of Johnson Research Group: It runs in one direction and eventually needs a break. "There's only so far a market can go before it gets oversold," Johnson says.

In other words, even a rampaging bear needs a breather now and then. In a bear market rally, despite weeks of losses, a bleak economy, and a raging credit crisis, stocks will bounce back. Temporarily.

To distinguish a bear market rally from a true market bottom, investors often look for extreme levels of pessimism. When investors get extremely pessimistic, they've reached the end of their selling, the theory says, and that's a great time to buy stocks.

Richard Sparks of Schaeffer's Investment Research says there is indeed a "tremendous amount of pessimism out there." But this time he doesn't think the high level of worry is positive for stocks. "There are some good reasons to be pessimistic," Sparks says.

Market Turmoil and Alternatives

Even as stocks held onto most of their recent gains Mar. 25, more storm clouds appeared: Consumer confidence plunged in March, while home prices, measured by new data from the U.S. S&P/Case-Shiller index, were down a record 10.71% in January from a year earlier.

Losses from the credit crisis continue to spread. Goldman Sachs (GS) analyst Andrew Tilton estimates U.S. financial institutions will record a total of about $460 billion in credit losses—half of those on residential mortgages.

The headwinds facing the credit markets and economy are so complex and changeable, it will be tough to tell when exactly the market hits bottom.

One positive sign for stocks is the dearth of viable alternatives. Treasury yields and other super-safe investments are so low they will probably do worse than inflation. That's illogical, says Bill Larkin of Cabot Money Management. But Larkin, a fixed-income portfolio manager, says it reflects the extreme conditions brought on by the credit crunch. Banks and other financial players are afraid to lend out money, a trend that could cut off economic growth and cause more market turmoil.

"It's going to get worse before it gets better," Larkin says.

The Bottom "Process"

Johnson says the market bottom is more likely to be a "process" than one single event. He's carefully watching the VIX index, a measure of volatility in the market that is traded on the Chicago Board Options Exchange. The VIX was above 25 on Mar. 25, and, through the worst of the recent crisis, the VIX has traded up to about 35. When this measure of fear hits 40, Johnson says, pessimism might finally have hit extreme, and bullish, levels.

But the main determinant of the market bottom is likely to be the U.S. economy. "We're facing an economy that really is in trouble," Johnson says, adding that pessimism will remain priced into the market until we see signs the economy isn't headed for a deep recession.

Another thing that might help the stock market? Some peace and quiet.

For financial stocks in particular, "it seems every news story that comes out is worse than the last," Sparks says.

If Bear Stearns was the last major victim of the credit crunch, mid-March, 2008, might very well be remembered as the time that stocks hit bottom. But few are willing to bet yet that the investment bank's collapse is the end of the story.

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