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One week stocks plunge 18%. The following Monday they soar 11%. Two days later they crater 9%. Talk of rampant bankruptcies, rising joblessness and maybe even another Great Depression fill the airwaves and cyberspace. That's probably hyperbole, but clearly the U.S. economy is on the ropes.
If all this leaves your head spinning, you're hardly alone. Never before have the nation and its citizens faced a financial crisis of such murky origins and elusive solutions. But in uncertain times such as these, it's important to avoid panicky moves and either stick to your plan or revise it thoughtfully and systematically.
To help you do that, we answer a baker's dozen of questions that are on the minds of many investors.
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1. Have the U.S. and foreign governments finally solved the financial crisis? It's too soon to tell, but you can't say the world's leading industrial powers haven't pulled out all the stops to tackle the root cause of the turmoil: frozen credit markets -- that is, the unwillingness of banks to lend to each other, to businesses and to individuals. Once it became clear that financial institutions and investors were not impressed with the U.S. government's $700-billion rescue plan, Western governments shifted into high gear, launching what economist Ed Yardeni calls "total war against the global credit crisis."
Among other actions, governments moved to install or expand bank-deposit insurance, inject capital directly into banks by buying ownership stakes -- in effect, partially and temporarily nationalizing a nation's financial infrastructure -- and guarantee that banks would make good on their loans to one another. The aim of these increasingly bold and dramatic acts is to restore confidence in the health of the major players in the global financial system and to encourage more lending.
2. What about the stock market? As investors learned of some of these remedies, they went on a buying spree, resulting in the October 13 "melt-up" in which U.S. stocks soared more than 11%. But the near-term future looks bleak. The economy is almost certainly in recession. How long or how severe it is hinges on how quickly the credit spigot begins flowing to bank customers. But a recession of any size or duration will put pressure on corporate profits. Kiplinger's expects gross domestic product to shrink through at least the first half of 2009, with the economy recovering weakly in the second half.
3. So should we take advantage of rallies to sell stocks, or at least refrain from adding to our stock holdings until the economy starts to turn? That's the $64-billion question. What makes investing tricky is that markets tend to anticipate the future. Bear markets end and bull markets almost always begin several months before the economy hits bottom and, typically, when the economic news is depressing.
The focus now is on whether banks feel confident enough to lend and whether they can begin to regain their financial stability. That was the purpose of those direct injections of capital into their balance sheets. If banks extend credit to their customers, the severity of a recession can be capped and it is possible to see an end to the economic misery on the horizon, even if it is months and months away. On such notes are bull markets born.
On the other hand, all recessions are accompanied by a litany of bad news. Every day brings revelations of lost jobs, lower profits and dim outlooks. These weigh heavily on investors' emotions, so it's possible stocks will continue to sink for months to come.
4. What about mutual funds? Funds are investment vehicles. They're as safe, or as risky, as the securities in which they invest. Of the major asset categories, stock funds are the riskiest, bond funds range from fairly risky to low-risk, and money-market funds carry the lowest risk.
5. Should I be worried that a money-market fund recently "broke the buck"? Probably not. When the Reserve Primary fund fell to 97 cents a share because of losses from its holdings of short-term debt issued by Lehman Brothers, it was the first time in 14 years that a money fund had broken the buck. So this is an exceedingly rare occurrence.
Still, short-term debt markets -- the area of the investment world where money funds roam -- have been so chaotic that we're reluctant to say that these funds are risk-free. The federal government's insurance program for money funds is more a bandage than a safety net (see What You Need to Know About Your Money-Market Fund).
If you want absolute safety, stick with Treasury-only funds, which are paying practically nothing. Or limit your money-fund investing to firms, such as Fidelity and T. Rowe Price, that have the wherewithal to make their shareholders whole should one of their money funds threaten to break the buck.
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