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How to Identify a 'Sucker's Rally'

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At first glance, fool’s gold cannot be distinguished from real gold. Even upon examination, novices are not able to discern the difference.

To avoid getting fooled, miners have come up with the acid test.

Most metals tend to bubble or fizzle when they come into contact with acid, precious metals don’t. Placing a small drop of a strong acid, such as nitric acid, onto the metals surface quickly and unmistakable differentiates real gold from fool’s gold.

Is there a time-tested method to distinguish a bull market from a “fools’ market?” Is the market “bubbling” right now (two-fold meaning of bubbling intended)?

A look at trading volume, investor sentiment and valuations provides a good acid test for stocks. Volume is the most basic technical indicator and measure investors comfort level associated with any given move.

The entire rally from March 2009 to April 2010 occurred on average daily trading volume (ADTV) of only 1.3 billion shares on the NYSE, 12% less than the ADTV seen from October 2007 – March 2009.

ADTV since the April 26, 2010 highs however, has increased 23% to 1.59 billion shares. Clearly, there is more conviction behind falling prices than rising prices.
A look at investor sentiment shows that there was no “wall of worry,” which new bull markets are supposed to climb. There was a capitulation in March 2009.

That’s why the ETF Profit Strategy Newsletter issued a strong and convincing buy alert on March 2, 2009.

Capitulations almost always result in lows. Most often, those lows prove to be just temporary if they are embraced too empathetically.

In April, various measures of investor sentiment clearly showed that investors had embraced the “new bull market.” The writing was on the wall. The stage for a major top was set.

If you use a road trip as analogy, valuations would illustrate the final destinations. Yes, there may be stops and detours along the way, but ultimately you will arrive at the destination.

Just the same, stocks always arrive at fair valuations eventually. Knowing the final destination, you can evaluation if you are on the right track. After a 14-month detour, stocks are once again en route towards fair valuations, which are much below current levels.

In summary, an analysis of a composite of time-tested indicators shows that the sucker rally from the March 2009 lows is coming or has already come to an end.

The ETF Profit Strategy Newsletter includes a detailed analysis of four reliable valuation metrics along with a target range for the ultimate market bottom.

Don’t get stuck with fool’s gold.