The Crash of 2008

Many years from now (like when the Nasdaq is back at 5000), your great-grandchildren might ask you, "What did you do during the Crash of 2008?" Perhaps you'll inspire them with tales of how, just like legendary investor Warren Buffett, you went on the bargain-hunting binge of a lifetime while Wall Street burned. Of course, you would probably be lying. It's more likely you have been hiding under your desk, watching pretty much all your investments sink farther and faster than you ever expected.

It's OK. Go ahead and tell the truth. The grandkids won't hold your caution against you once they understand how scary things seemed on Wall Street in the autumn of 2008. Months of trouble in the housing and credit markets spawned what became an absolutely stunning decline in stocks, leaving confidence a shambles on both Wall Street and Main Street. During eight blustery trading days beginning in late September, horrified investors watched the Dow Jones industrial average tumble nearly 2,400 points, including a sickening 18 percent drop in a single week. Pundits began comparing the dizzying fall to two other market plunges, Black Monday in 1987 and the 1929 crash heralding the Great Depression. "It's a good old-fashioned panic," says Richard Sylla, a market historian at New York University's Stern School of Business.

Sure, there was that 936-point surge in the Dow following the government's plan to buy $250 billion worth of equity in ailing banks. Maybe in hindsight that will be seen as having been the all-clear signal for stocks. But then again, it might have merely been a sucker's rally, not the end of the bear market. And even if the worst is over, it often takes months—sometimes years—for the market to regain enough strength to power a sustained move higher.

Cheap? There are hopeful signs that fear in the market may have reached its zenith. By comparison with the bear market of 2002, evidence of overdone selling is becoming clearer. Analysts at Ned Davis Research say the steep declines in early October resemble the "type of waterfall decline that occurs at the end of bear markets when fear feeds on itself." Various gauges of market panic are hitting all-time highs.

The VIX index, Wall Street's so-called fear gauge, is well above levels seen during the 2002 bear market. "We're getting the capitulation," says Ed Clissold, a senior global analyst at Ned Davis. Certainly by some measures, the market is now looking awfully cheap. For instance, the S&P 500's forward price-to-earnings ratio is 11.2, as low as it has been since the bear market of 1990. But that number may actually be too rosy, given how much unseen damage the credit crisis may be inflicting upon the economy.

So as bad as it is, there could be farther to fall. Earnings weakness is a worry. In bear markets, share price declines often more or less match the fall in corporate earnings, explains chief economist Michael Darda of MKM Partners.

In 1990-91, stocks fell 20 percent while earnings lost 27 percent. In 2001-02, shares lost 49 percent vs. a 40 percent earnings decline. "So if profits bottom not much more than 44 percent or so from the 2007 peak, the market may be close to the new lows," he says. Unfortunately, he says profits could fall 60 percent this time around.

Damage assessment.What will stocks look like when they (eventually) bounce back? Normally, post-bear rebounds see investors move back into riskier companies. This time, broad shedding of the use of leverage, or borrowed money, across the economy means that may not happen. Companies, like banks, are making sure, at the expense of new investment, that they have enough cash to fund their operations in tough times. "People with weak balance sheets aren't going to be in a position to expand and grow their businesses and do well. In fact, it will be the opposite. The strong get stronger; the weak get weaker," says Stephen Auth, chief investment officer for global equity and asset allocation products at Federated Investors, who oversees more than $37 billion in equities. Merrill Lynch calls consumer staples, healthcare, and tech the market's most "stable and consistent growth properties."