Why you should beware of big market rallies

published 19 November 2008

I've been studying the markets harder than I've ever studied before.

In the past few weeks, I've read a dozen textbooks on economics. I've also been watching the markets night and day on CNBC (with the sound turned off). I've only been sleeping four or five hours a night. And when I'm not reading books or studying the market action, I sit in my armchair with my eyes closed and contemplate the events going on around me.

Volatility is one indicator I've been thinking about. It's astonishing. For example, on Thursday, the Dow Jones logged its fourth biggest daily gain in the stock market since the Second World War... a gain of 6.7%. The highlight of the day was the 12.5% rally in the afternoon that erased a 4% morning decline.

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On Friday, the market fell 5%, recovered all its losses by midday, and then fell 5% again.

It's a big deal when the stock market moves by more than 5% in one day. Since 1940, it's happened on average once every 734 trading sessions.

I analysed the number of 5% moves up and down in the Dow Jones Industrial Average since September 1929. Here's what I found:

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Decade	Daily movesover 5%
1930s*	95
1940s	3
1950s	1
1960s	1
1970s	1
1980s	6
1990s	2
2000s	4
Last 2 months	9
*includes last 3 months of 1929

Volatility is always highest in bear markets. Notice the volatility in the 1930s, for example. And the six occurrences in the 1980s all came around the 1987 stock market crash. The two in the 1990s arrived during the Asian crisis.

Here's something else I've noticed: The best stock market rallies happen in bear markets. The Great Depression featured almost all of the best stock market rallies of the last 80 years. One of the most famous bear-market rallies occurred in early 1930. The Dow crashed from 301 on October 28 down to 230 by Christmas 1929. Then it recovered back to 294 in April 1930 before falling to 41 by 1932. They say investors lost more money in the bear market rally of 1930 than in the crash of 1929.

Check out this list of the top 10 rallies in the Dow since 1929. They all occurred in bear markets:

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Date	Gain (%)
15-03-1933	15.35
06-10-1931	14.87
30-10-1929	12.34
22-06-1931	11.90
21-09-1932	11.36
13-10-2008	11.08
28-10-2008	10.88
21-10-1987	10.15
03-08-1932	9.52
05-09-1939	9.52

As I look for investments for my readers, I'm going to assume we'll be in a bear market for some time to come. I'll be looking at only the safest investments... like cash, gold, T-bills, and blue-chip stocks with safe dividends.

With cash and defensive investments, your buying power increases as everything else falls. And with high-quality dividend payers, the stable income they spin off will act like ballast in the stock price and prevent them from falling too far.

Also, I'm going to expect incredible bear market rallies. Until the volatility subsides, I'll take these rallies as confirmation of a continuing bear market and not the beginning of a new bull market...

This article was written by Tom Dyson, co-editor of the free daily investment newsletter DailyWealth.