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(Scott Olson/2011 Getty Images)
(Scott Olson/2011 Getty Images)


A five-point reality check on the market euphoria Add to ...

With stocks enjoying their biggest one-day blast-off in three-and-a-half months on Wednesday, investors are no doubt scratching their heads in wonderment over what this rally means in the longer term. Here are five thoughts.

1. Sharp rallies underline the dangers of making big, lopsided bets on the stock market. Just as being too bullish on stocks can hurt your portfolio during downturns, being too bearish can really smart during upswings.

This particular rally came out of nowhere, and followed a recent seven-day losing streak for the S&P 500 amid lots of doom-and-gloom predictions. The fact is, market timing is nearly impossible to get right, so wise investors stick with a prudent mix of stocks and bonds that reflects their risk tolerance.

2. Not all stocks benefited equally. Sure, the rally was broad, lifting the vast majority of stocks within S&P 500 and the S&P/TSX composite index. As the saying goes, this was a “risk-on” rally.

But there were big differences among the various sectors within major indexes: Commodity producers and financials surged the most, while some of the more defensive areas of the market, like consumer staples and utilities, lagged.

This supports the need for diversification if you want a smoother ride as the market navigates between economic hope and despair.

3. Investors still respond to grand gestures from policy makers. That suggests they believe that central bankers and others exert a lot of control over the global economy, which is comforting to anyone fearing a return of financial chaos.

After all, it isn’t hard to find the source of the rally: Stocks popped after central banks announced a co-ordinated policy to make it easier for commercial banks to get U.S.-dollar loans, increasing the flow of credit to people and businesses. Hey, maybe there are plenty more levers at their disposal.

4. The heft of the rally reflects how much pessimism has been built into stocks. The upsurge comes as economists, strategists and other forecasters busily slash their forecasts for everything from corporate earnings to economic growth.

Just this week, the Organization for Economic Co-operation and Development cut its forecast for U.S. growth in 2012 to 2 per cent from 3.1 per cent, while Europe will be lucky to grow 0.2 per cent next year – and some observers believe the OECD is being over-optimistic.

Now, you can almost hear the sighs of relief over the appearance of some better-than-expected news from central bankers and the U.S. economy, where an employment report pointed to strong private-sector job gains in November.

5. Not all rallies can be sustained. It is tempting to equate big market moves – up or down – as votes of confidence over the direction of the market. The bigger the move, the greater the confidence.

However, big moves can just as easily reflect an over-emotional response to something that is inconsequential in the longer term, and this response can shift fast.

Just take a look at market action during the terrifying 2008-09 bear market: The S&P 500 saw 16 one-day rallies of 4 per cent or more, including two days when the index surged more than 10 per cent. Yet, the overall direction was down, down, down. The S&P 500 fell 54 per cent over this period.

Right now, the index is down just 9 per cent from its recent high in April. For those who suspect there is worse to come in the global economy – and Europe’s sovereign-debt crisis in particular – the downside risk looks stronger than the upside appeal.

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