To what extent will the European debt crisis affect the markets? That's the most important question of the day. Are we going to see a double-dip recession? If so, will it affect the markets worse than Lehman's bankruptcy? The actual answers to these queries would be worth their weight in platinum, gold and silver combined.
But since no one can predict the future, we can do the next best thing, which is look to history to offer some possible signals. Signals are valuable. As I tell my investment partners, preservation of capital is always the top priority in investing. And if you are caught sleeping at the wheel because you are following headlines, your assets could shrivel up before you even know what hit you.
If you really want to cover to your bases and be safe, then you need to go back and look at what happened to the markets leading up to during the Great Depression. Things really started to heat up during the mid-1920s. Everyone loved stocks: Housewives were buying them up with their grocery money. No one back in 1925 or 1926 would have considered taking a cautious approach. After all, in 1926, the Dow Jones Industrial Average (DJIA) advanced from about 140 to nearly 400 by the fall of 1929. Then Black Tuesday occurred, and the DJIA fell to 200 in a manner of months. Those who were bullish in 1926 -- virtually everyone -- saw the decline from 400 to 200 as a signal that stocks were cheap again and piled back into the market.
Those investors were rewarded when the Dow raced up to 300 less than a year later. Never mind that unemployment was surging higher or that industrial production was rapidly decreasing -- the risk was missing another "roaring" period for stocks. Then came the second stage of the market decline, and that proved to be the killer: In 1932, the Dow dropped more than 90%: from its high of nearly 400 in 1930 to 41. No one was spared.
Fast forward to late 2009, which marked the first stage of the latest market decline. This was followed by a huge bull run which, despite the recent market selloff, is still going: The market is up more than 75% since the March 2009 bottom. The European crisis seems to be the second stage, and we are all waiting to see how it will play out.
The point I want to make is that the S&P 500 could bottom at 1000 or possibly lower than the 666 bottom it hit in March of 2009. But prudence demands awareness of the possibility of a worst-case scenario. The conclusion for investors is to consider hedging against a catastrophe and on the equity side, be looking in areas where the worst is already priced in (this is what I'm doing in my fund). That doesn't mean the share price can't decline further; it means that when the U.S. economy does start going again, your investments will prosper.
Both MasterCard (MA) and Visa (V) are two names to watch. These businesses virtually have no capital expenditures and no real inventory to speak of, and more people every day are opting to use a debit or credit card instead of cash or a check. Online bill paying will continue to rise dramatically -- especially with the turmoil the U.S. Postal Service is going through. And as people gravitate toward direct deposit to save on banking fees, it will be much more convenient (and safer) to use a card than to withdraw cash.
Because of the concern of large financial institutions, small regional banks are babies being thrown out with the bath water. These are the banks that make money the old-fashioned way: They use spreads between deposits and loans. All banks are going to have to do this for the foreseeable future. Capital Federal Financial (CFFN) is a pristine example of a high quality, well-run bank. Its shares trade below book, yield nearly 3%, and the company's capital ratios are well above minimum requirements. CFFN could survive a double dose of any stress test you give it.
So, indeed, the market does pose significant risk, but that's inherent to investing. Risk need not be a deterrent to completely avoid investing. Understanding the various outcomes and building your portfolio around those scenarios can yield satisfactory results.