Be Wary of Sharp Rallies in an Overall Down Market

The average investor can get very tired of seeing the market bleed its way downward on a daily basis, and understandably so. Severe corrections or bear markets tend to occur in time periods where the economic news is relentlessly negative or valuations have just gotten out of hand. As someone who has worked in the investment industry for quite some time, I find that one of the most common mistakes the average investor makes is reading too much from a very short-term sharp rally in the market.

If you take a look back in history you will find that some of the biggest single day point gains for the major indices have come during a bear market or severe correction. The three single biggest daily point gains in the Dow's history are all in the time period from October 13, 2008 to November 13, 2008. I probably don't have to tell you that this period in the fourth quarter of 2008 was a horrific time for the stock market. In fact, the Dow Jones Industrial Average lost 18.5% of its value in the fourth quarter of 2008 alone. The Dow would then go on to lose another 25% or so before rallying starting in March of 2009. What's the point of this history lesson? The point is that a sharp single day rally should be viewed with extreme caution. These rallies are generally not based on any fundamental change in the market, but rather they are typically a relief rally or a rally caused by shorts covering and locking in their profits.

It is vitally important that investor keep an eye on the longer term trends and not just a day or two worth of data. The old saying "one day does not make a trend," couldn't possibly be more true. The individual investor who takes these sharp rallies as a sign that they should put their money back to work is in severe danger of being hurt. I typically would advocate using massive short-term rallies in an otherwise downward trend as a good time to get out of stocks and buy back at a lower price.

The next time you see the stock market up by several percent in one day; consider the reasons for that gain. Has there been a fundamental change in the market or the economy? If the answer is no, you should be extremely skeptical of the potential longevity of this rally. Remember, one or two day tremendous rallies often occur as the market is about to head lower.