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As economic concerns mounted during the first quarter of 2008, the stock market continued its slide. The broadest U.S. index, the S&P 500, had negative returns of 9.4% in the first quarter. It was the worst quarter for the S&P 500 and each of the major indices shown in the table below in 5 ½ years. From its peak in October 2007 to its lowest point in March 2008, the S&P 500 fell by 18.6%. All of the other major indices presented below fell by an equal or greater amount.

The following table (click to enlarge image) shows the total returns of major stock indices for various time periods. The third column in the table indicates the full extent of the current correction, measuring from the high to low daily closing price.

A number of factors contributed to investor pessimism in the first quarter. These included a slowing economy, a weak dollar, growing unemployment, and a stagnant housing sector with record foreclosures and falling prices.

However, matters became critical with the near collapse of Bear Stearns (NYSE:BSC), the fifth largest investment bank in the U.S. It took a weekend deal orchestrated by the Federal Reserve to stave off bankruptcy, by getting J.P. Morgan (NYSE:JPM) to agree to an acquisition at the rock bottom price of $2 per share (subsequently raised to $10). While the past year has seen a number of companies directly related to the mortgage industry go bust, the Bear Stearns crisis came as a shock to most observers. Bear Stearns’ shares have traded as high as $159 in the past 12 months, and the firm was generally regarded as one of the most prestigious on Wall Street. The loss that it reported in the fourth quarter of 2007 was the first in its 85 year history. The deal to bailout Bear was the first of its type since the Depression.

The collapse of Bear Stearns and the problems of many other financial institutions in large part can be blamed on credit markets which have become largely dysfunctional. It began in late 2006 when mortgage companies could no longer raise funds by selling debt securities that were collateralized by the underlying mortgages of homeowners. Unable to raise new money and experiencing high levels of defaults, the majority of these companies were forced out of business. Worries about risk spread to other sectors of the credit market. Mortgaged backed securities issued by Fannie Mae (FNM) and Freddie Mac (FRE), regarded as AAA in quality due to the implied backing of the U.S. government, fell in price. The student loan market ceased to function properly, causing government-sponsored programs such as PHEAA to halt the issuance of new loans. Companies that relied on the issuance of commercial paper and corporate bonds in order to fund operations and retire maturing debt could not find buyers. The municipal bond market suffered as the market for auction-rate securities collapsed and investors worried about the credit worthiness of the municipal bond insurers.

One might argue that the credit markets have been dysfunctional for some time – previously credit was too easy to get, now it is virtually impossible. Just two years ago, almost any individual or company could borrow money with ease. In some cases, home loans could be had with no money down and no proof of income. Corporate mergers and acquisitions were running at record levels as companies had no problem finding willing lenders. Now the opposite is true.

In the first quarter, the Federal Reserve took significant steps to try to provide liquidity and restore confidence to the financial system. It lowered its target rate from 4.25% to 2.25% and provided investment banks with access to short-term funds. By participating in the bailout of Bear Stearns it provided a signal to the markets that it won’t let matters spiral out of control. Congress and the executive branch put together a tax rebate stimulus package, and there is a good likelihood that there will be some federal relief for homeowners facing foreclosure and for the housing sector in general.

All that sounds like a crisis – and it probably is. Are we out of the woods? That’s hard to say. We’ve experienced a steep stock market correction (some might call it a bear market), and it feels to most of us like we are in a recession (whether or not the economists define it as such). However, there is some room for optimism.

First, with its steep correction, the market has possibly already discounted many of the negative factors mentioned above. The S&P 500 Index has fallen for five consecutives months. The last time that occurred was October 1990 in the middle of another banking crisis, which was brought on by the failure of more than 1,000 savings and loan banks. Over the next twelve months the S&P 500 rose 33.5%, despite the fact that the economy was in a recession from July 1990 to March 1991.

U.S. and foreign governments have been proactive in trying to restore stability to the global financial system and to stock and bond markets. While more problems are likely to appear before the situation markedly improves, the willingness of governments to provide support should help to restore confidence.

While the U.S. could very likely experience a recession, strong growth in emerging markets (i.e. China, India, and Brazil) should help to lessen the magnitude and duration of an economic slowdown. Indeed, U.S. exports and foreign operations of most U.S. companies remain very strong.

It remains to be seen if the U.S. slips into an “official” recession (defined as a decline in real gross domestic product [GDP] for two or more consecutive quarters). Keep in mind that recessions are generally short in duration. Since 1980, there have been four recessions which have averaged 9.5 months in length. Over this time span, the U.S. economy had been in a recession 12% of the time and in an expansion phase 88% of the time. Typically stocks begin their recovery before the end of the recession, as the market usually anticipates a recovery before there are visible signs of improvement.

While the past five months have been disappointing for most investors, stock market corrections are a normal facet of our economic system. The mistake that many investors make is to sell when the market is low as they fear that prices will fall even further. However, over past periods when the S&P 500 Index was lower than it was one year earlier (as is now the case), the following two years usually generated very strong performance (averaging 26.8% since 1975). This reflects the simple fact that bull markets follow bear markets, just as economic expansions follow recessions. Although it might be difficult to remain optimistic in light of the current problems, patient investors should be rewarded with attractive long-term performance as signs of a recovery begin to emerge.