NEW YORK (MarketWatch) -- Stocks rallied to a sharply higher close Monday, sending the Dow industrials up by over 280 points for its best day since 2003, as investors snapped up financial shares, which have been heavily hit in recent weeks amid concerns about credit markets and bad home loans.

"When you snap a rubber band too much one way, it has to kick back the other way," said Donald Selkin, director of equity research at Joseph Stevens, referring in particular to financial shares.

"They've been coming down so much recently, with all the bad news about Bear Stearns and others," he said. "Is it sustainable? We'll see. We were at very oversold levels for this market, but we have to be a bit skeptical as long as the Nasdaq keeps lagging badly behind."

The Dow Jones Industrial Average DJIA, -0.47% finished up 286 points at 13,468, marking its best one-day performance since June 2003, and making up for its 281-point plunge on Friday.

Out of the Dow's 30 stocks, 29 advanced, led by financial shares such as American International Group. AIG, -1.23% , Citigroup Inc. C, -2.12% , and JP Morgan Chase & Co. JPM, -0.84% .

Also on the Dow, Merck & Co. Inc. MRK, -1.03% gained 2.1% after Cowen & Co upgraded the stock, while Wal-Mart Stores Inc. WMT, -0.08% rose 3.3% after saying it is setting up a joint business-to-business venture in India.

The S&P 500 SPX, -0.48% gained 34 points to 1,467, while the Nasdaq Composite COMP, -0.29% rose 36 points to 2,547.

"There's also hope that the [Federal Reserve] is going to change its tone," Selkin said.

While the central bank, which meets Tuesday, is widely expected to leave interest rates unchanged, investors hope it will signal some concern about credit markets.

Trading volumes showed 2.2 billion shares exchanging hands on the New York Stocks Exchange and 2.8 billion shares trading on the Nasdaq stock market. Gaining issues topped decliners by 17 to 15 on the NYSE, while decliners topped gainers by 8 to 7 on Nasdaq.

S&P, others to the rescue

The rally accelerated in afternoon trade after a managing director at Standard & Poor's said that the market had overreacted to S&P's decision Friday to lower its ratings outlook on Bear Stearns BSC, -10.00% .

Some investors are also trying to find some value in some of the most battered shares of the financial sector.

In a note, Thomson Financial analyst Michael Thompson said that four broker/dealers Morgan Stanley MS, -2.35% , Merrill Lynch MER, +27.69% , Lehman Brothers LEH, and E-Trade Financial ETFC, -2.33% are among the most undervalued stocks of the sector.

E-Trade Financial ETFC, -2.33% rebounded from heavy pressure earlier to finish up 1.5%.

Meanwhile, Merrill Lynch MER, +27.69% jumped 6.4%. UBS upgraded the stock to a buy rating, saying the fallout from the mortgage and credit businesses is mostly priced into the stock at this time.

Another stock that got an upgrade from UBS was TD Ameritrade AMTD, -1.09% . The stock was up 1.9%.

Financial woes

The bankruptcy filing from American Home Mortgage AHM first accentuated credit-market worries in morning trade.

On Friday, those concerns and a weak jobs report drove a sell-off that marked the Dow's third worst day of the year. The Dow fell 281 points, the S&P 500 fell 39 points, and the Nasdaq lost 64 points.

The declines followed a downgrade of the outlook for investment bank Bear Stearns BSC, -10.00% by Standard & Poor's on concerns about its reputation, its exposure to mortgages and mortgage-backed securities and on debt taken from unsuccessful leveraged finance underwritings.

Over the weekend, Bear Stearns assigned blame for its troubles. Warren Spector, its co-president and co-chief operating officer, resigned.

Art Hogan, chief market strategist at Jefferies & Co. tells MarketWatch that traders are hoping to "find some stabilization," following last week's tough losses. Listen to Hogan.

The credit worries persisted Monday, but some investors believe that recent selloffs have been excessive and that there are attractive bargains for the taking. The market is eager for the Federal Open Market Committee's decision on interest rates on Tuesday.

"The market remains very jittery," said Peter Cardillo, chief market economist at Avalon Partners. "The focus now will be on the Fed decision. I don't expect it to cut rates tomorrow, but I do think the market is correct in thinking that if the situation worsens, the Fed may say it is ready to injection liquidity and cut rates."

"Right now the market needs to calm its nerves, but it will be hard to do so," he said. The fed funds rate stands at 5.25%. The central bank has left rates unchanged since June, 2006.

Stocks in action

Shares of American Home Mortgage AHM were halted, after the mortgage lender forfeited most of its market capitalization in recent sessions. The company, which last week revealed that many of its creditors were demanding their money back, revealed its bankruptcy petition in a government filing.

Another mortgage lender, Countrywide Financial CFC, revealed in a Securities and Exchange Commission filing its liquidity sources as of June 30. It had a net $186.5 billion available, and characterized various sources by reliability as high, moderate, moderate-to-high and moderate-to-low -- with $81.3 billion in agency and private-label MBS and ABS falling into the latter category.

Shares of the French bank Natixis climbed in overseas trade after the company held to its 2007 profit outlook and said it's cut its entire loan exposure to U.S. subprime mortgages and two-thirds of its trading exposure.

Crude oil tumbles

Crude oil futures came under severe pressure, with the front-month crude contract falling $3.42, or nearly 5%, to close at $72.06 a barrel. Traders are worried that a slowing U.S. economy will result in lower energy demand. See Futures Movers

The front-month gold contract also fell, losing $1.10 to $683.30 an ounce. See Metals Stocks.

Treasurys fell as investors removed safe haven positions amid the rally in stocks. The benchmark 10-year Treasury finished off 11/32 at 98-7/32 with a yield $TNX of 4.729%. See Bonds.

The dollar fell against the euro and the yen early Monday, continuing to react to last week's weaker-than-expected employment and services-sector growth data. "Traders are sidelined until Tuesday's FOMC meeting, as they try to determine the Fed reaction to the latest problems in the housing sector," said Boris Schlossberg, senior currency strategist at DailyFX.com. See full story.