Panic No. 12

David Dreman 10.15.07, 12:00 AM ET

The capital markets have suffered mightily in the mortgage meltdown. Mortgage-backed securities--whether backed by nasty subprime loans, slightly better Alt A ones or even highly rated borrowings, have sunk. Junk bonds, often linked to MBSs, are hard to float. Private equity deals, frenetic not so long ago, are iffy now that high-yield funding is harder and costlier to provide.

That has introduced intense fear to stock- and fixed-income investors worldwide. Despite the Federal Reserve's half-point reduction in mid-September, there's still a lurking suspicion that more bad news lies ahead. What will happen when all those adjustable-rate mortgages reset upward in months to come, plunging more strapped homeowners into default? Are we approaching a financial meltdown that will take everything, including the stock market, into a dizzying drop not seen since the bear market of 2000--02?

Yes, it's bad now and could take many months to unwind, hurting swarms of investors who were suckered into going for sky-high returns of MBSs without examining the ridiculously poor security behind them. Ditto some of the convoluted securities that bundle them called collateralized debt obligations. The mortgage problem also could put a dent into economic growth for a while. But as all good value investors know, dire times bring opportunities. The long-term trend of the stock market is up.

Since coming to Wall Street in the late 1960s, I have been through seven such crises. Somehow, the market survived them and thrived. Look back even further to the period following the end of World War II, and sure enough, you'll find that pattern holding in four more market spills. Beginning with the first postwar panic, resulting from the 1948--49 Berlin blockade, stocks have tumbled only to come roaring back to new highs. The worst market break came in 1973--74, during a nasty recession and the Arab oil embargo. The most recent was the dot-com slide, which began in March 2000 and ended in late 2002. The Nasdaq Composite, heavy with tech names, still has not regained the ground lost in that crash, but the broad indexes have.

During each crisis investors felt confused, uncertain and panicky. They believed nothing in their previous experience could help them cope with the ominous new world they faced. "Sell, sell, sell," their inner worrywarts advised. "Save your capital before it's too late."

This almost always turned out to be a bad move. Selling in a crisis is foolish. Yes, if you had sold the S&P 500, say, a year into the bear market, in March 2001, you would have avoided another 28% decline before it hit bottom. But would you have had the wisdom to get back into stocks a year and a half later? I don't know of anyone advising an exit in March 2001 who also switched to a bullish stance in fall 2002. And if you had sold in March 2001, and stayed out, you would have missed an opportunity. Since then the stock market has returned 46% (including dividends). On average, for each of the dozen crises, the market was up 36% one year after the low point, 44% after two years.

Today's stock market remains solid with good fundamentals and many cheap stocks at hand. The ongoing liquidity crisis must be handled gingerly, of course. Commit your capital slowly as several more shocks must be absorbed before a broad market rally begins.