Stocks: A Place Called Vertigo

With the Bear Stearns collapse, equities' age of anxiety just got an extra jolt of caffeine. Should individual investors give up on stocks?

The year 2008 is turning into the ultimate stress test for investors.

The troubles pile on top of each other: wild volatility in stock prices, a housing slowdown, a subprime credit crisis, and, most recently, a probable recession. Oh, yes, and steadily climbing food and energy prices.

Then, on Mar. 14, confidence collapsed in an 85-year-old investment bank, Bear Stearns (BSC). By Mar. 17, as JPMorgan Chase (JPM) bought up the wreckage of the once-proud firm at a rock-bottom price, a concerned Federal Reserve jumped into action to prevent that crisis from sinking the entire financial system.

Danger Still Lurks

As if to illustrate the erratic, volatile nature of the markets these days, the blue-chip Dow Jones industrial average actually posted a small gain Mar. 17, while broader U.S. market measures like the Standard & Poor's 500-stock index recorded modest losses.

But good news has been rare. At each new sign of big trouble, individual investors are given the prudent mantra: Don't panic or do anything rash. Selling stocks now will only lock in losses and hurt your long-term return.

Each terrifying headline makes it harder to hold on. Yes, the stock market has provided solid returns over history, but maybe, investors ask, this time is different?

The danger is real. "While the old adage says it is always darkest before dawn, we think that it's going to actually get a bit darker before we start to see the light (or a flicker)," UBS (UBS) financial sector analyst Glenn Schorr wrote Mar. 17. The "liquidity squeeze"—the marketwide shortage of cash that did in Bear Stearns—has high odds of getting worse before it gets better, Schorr says.

Global Effects of Housing Meltdown

The problems at Bear Stearns are linked not just to bad investments, but to the broad, deep decline in U.S. home prices. The damage from the U.S. housing crisis could be severe.

Many investors were hurt by the popping of the tech bubble in 2000 and 2001, but housing affects far more Americans, says Scott Armiger, who manages $1.7 billion at Christiana Bank & Trust Co. in Delaware. "It touches more lives."

Investors might be prepared for a mild slowdown in the U.S., but a deep, global recession would heighten the already considerable levels of pain in the market.

Bargains for the Brave

Despite all this, professional investors and market experts urge individual investors to keep the faith: If you're investing for the long term, keep your money in the stock market. If you're especially brave, this might be the perfect time to buy equities.

Don Hodges, a 48-year market veteran of Hodges Capital Management, saw bargains amid the steep decline in stock indexes on the morning of Mar. 17. He bought stocks, including U.S. Steel (X), that he thought were unlikely to be affected by the financial turmoil. "There are great buys there," Hodges says.

Never buy stocks you're not willing to own for five years, Armiger says. "If you're buying today and you promise yourself you won't sell for five years, there are a lot of great companies out there," he says.

Of course, getting from now until Year Five might be tough. That's especially true for large financial stocks, menaced by the same forces that took down Bear Stearns.

But there are some banks that didn't take on risky subprime debt. There are smaller financial firms, says John Thornton of Stephens Investment Management, "not big enough and sophisticated enough to get in the troubles the big guys have."

There are also vast parts of the economy that have so far resisted recessionary forces. Health care, mining, tourism, and oil are examples.

"We're in a dual economy," says Brian Gendreau of ING Investment Management (ING). "Some parts of the economy are undoubtedly in recession, but other parts are doing quite well."

Signaling an End to the Crisis

For an expert on financial crises such as Paolo Pasquariello, a professor at the University of Michigan's Ross School of Business, the Bear Stearns meltdown is, on balance, a positive sign. That's because it got the Federal Reserve involved in a big way. "It could have been a massive crisis if [the Fed] didn't do anything," Pasquariello says. "Now, investors know the Fed is alert to the situation."

John Merrill, a 34-year market veteran at Tanglewood Capital Management in Houston, agrees. Big headlines and blockbuster financial collapses often indicate the market is near its bottom, Merrill says, because those events finally show everyone the seriousness of the situation. The Bear Stearns debacle gets the Fed and other regulators to redouble their efforts to fix the damage. "The government has the power to get us out of this," Merrill says.

That may be the best reason for long-term investors to stay in the stock market, despite the rough ride ahead. The recession might be deep. The credit crunch could worsen.

But, eventually, the current U.S. financial crisis will end—either with a bang or a whimper.

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