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What history tells us about market slumps

The Baltimore Sun

When history repeats itself in the stock market, investors dutifully follow the script.

The villain this year is the subprime mortgage situation, and the temporary hero is the Federal Reserve. The investor's role is a repeat performance that has been reviewed many times over by stock market historians.

Too bad so few people ever get around to learning from history.

"Some people will get killed in this stock market and other people will get frightened, and everybody will swear never to do this again, and yet they will," said Peter Bernstein, president of Peter L. Bernstein Inc. economic consulting in New York and author of Capital Ideas: The Improbable Origins of Modern Wall Street.

The current market has the potential to become a disaster, though Bernstein doubts it will. The subprime credit situation does not represent a widespread stock market bubble in the same sense that 1929, 1969, 1987 and 2000 did, he said.

A sharp turn in the stock market can occur when investors stop disagreeing about the outlook for the economy and markets. Universal agreement provides a strong push.

"As it is happening, the investor must ask, 'When will I have the courage to start to buy?' " Bernstein said. "Because that's what buying opportunities come from."

Tumult always has underlying reasons. Government policies in London and Washington, not Wall Street speculation alone, led to the 1929 market crash and Great Depression, Bernstein said. High inflation in 1969 and high unemployment leading up to the 1987 crash helped to whack the markets, while the dot-com period "was so crazy that today is baby stuff compared to it," he said.

Because of new revelations about declining credit, expect a delicate market, flustered investors and a generally erratic remainder of 2007, experts said.

"The current problem is not so much a stock market problem as it is a credit problem, and what we're seeing in stocks is just a reaction to it," said Richard Sylla, professor of economics and financial history at New York University's Stern School of Business. "I don't think it'll be so bad since the Federal Reserve is prepared to provide the liquidity to let the market stabilize."

Sylla said the Federal Reserve has had 28 years of good leadership and exhibits a much better understanding of history and how credit and the financial markets operate.

"What can we learn from history?" asked Harold Bierman Jr., a professor of business administration at Cornell University. "Basically, that you need to be diversified and your stock investment can still lose 20 or 30 percent easily, anytime."

He said there are definitely worse things you could do than hold on to your stocks. After the market recovers from a sharp drop, you'll be ahead. Markets always move on and have a memory.

For example, investors in the markets from 1945 to 1970 had to gradually realize that 1929 wasn't going to occur every other day and they could still make money by buying and holding, Bierman said. Deciding to buy stocks in 1933 was a bold decision, and that same choice can still confront investors.

"I was too wise to buy into the Internet bubble and I missed out on Google," Bierman said. "Every time you make an easy generalization about how stupid people are, some bright people like me will be just as stupid."

"History is extremely important to investing, but doesn't provide nice, simple, easy-to-read road markers," said Hugh Johnson, chairman of Johnson Illington Advisors LLC in Albany, N.Y. "You still have to use judgment and manage your portfolio accordingly."

The current gyrating market represents one of nine normal cycles that have occurred since World War II, as Johnson sees it. Each is characterized by a stock market cycle, followed by a business cycle, followed by an interest rate cycle, he said. These are inevitable, and they produce some periods of mania along the way.

"For example, the housing mania has the stage of speculation, followed by the stage of distress, followed by the stage of revulsion," he said. "We are currently moving from distress to revulsion."

In the "revulsion" stage, speculators race for the exits and revelations about what took place in the earlier speculative stage rock the stock market, he said. Even if fundamentals are good, he said, we can expect this negativity to be a part of the market fabric for the next six months.

"But it is nonetheless much easier to deal with a market cycle if you understand the anatomy of a market cycle or a mania," Johnson said. "It is easier because nothing fazes you."

So now we know the lesson: History shows it makes the most sense to stay put with your investments. Yet human beings aren't always sensible.

Andrew Leckey writes for Tribune Media Services.

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