One Year Later: To hell and (almost) back?

Remember when markets were efficient and self-correcting, the subprime crisis was contained, the U.S. economy was decoupled from the rest of the world -- and all you needed to be Fed chairman was an abiding love of Ayn Rand?

If nothing else, the market's movements over the last year -- or ever since the global financial system went down like the Hindenburg -- have disabused us of such quaint notions regarding the wonderful world of equities. Forget about trading on technicals and fundamentals. The market runs on Fear and Greed.

About this time in 2008 the Dow Jones Industrial Average and broader S&P 500 were down roughly 15 percent for the year. Those were some seriously painful declines -- but, brother, does a measly 15 percent shellacking look good right about now.
Yes, we lost more than 25 percent on the Dow by early March -- and now it's up almost 10 percent in 2009. But over the last 52 weeks? The beloved blue-chip index is still off more than 15 percent, and it did so in the most volatile, gut-wrenching fashion.

So let's recap the last year of trading, beginning, of course, with Fear. The trading day before Lehman Brothers blew up (Friday, Sept. 12), the Dow stood above 11,400. Less than a month later it was struggling to regain 9,000 -- and was swinging by a thousand points or more on some days. (Efficient market theory, indeed.)

Kim Caughey, senior equity analyst at Fort Pitt Capital Group and the Fort Pitt Capital Total Return Fund (FPCGX), did what probably every market pro was doing during those terrible weeks in September and October of 2008: She was getting up in the middle of the night to watch Bloomberg Asia TV, trying to get a bead on what new horrors the overnight action would mean for the U.S. markets in just a matter of hours. "It was a tense time," she says, using understatement to good effect.

After all, in a whirlwind of days, mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) were put into government conservatorship, Lehman went bankrupt and insurance giant American International Group (AIG) largely became the property of U.S. taxpayers. Washington Mutual, once the biggest savings and loan in the nation, was consumed by JPMorgan Chase (JPM). Bank of America (BAC) was strong-armed into buying Merrill Lynch and -- perhaps worst of all -- a giant money market fund "broke the buck," something that is just not supposed to happen. Ever.

"We finally understood how linked together the world of finance is," says Caughey. "The quick shut down of the credit markets was remarkable, especially when there was the specter of a run on banks with respect to money market funds and the fear of 'breaking the buck.'"

Once the enormity of counter-party risk in the financial system became apparent, there was no stopping the slide. Financial stocks cratered, taking the rest of the market with them. (Counter-party risk is kind of like betting on a football game in order to make your mortgage payment and winning big, but when you go to collect, your bookie is broke.)

By mid-November the Dow touched 7,500, and if you wanted out of stocks, there was no place to hide. The bedrock concept of asset allocation gradually grinded to a halt. Domestic and foreign stocks, bonds, oil, real estate? Forget it. Supposedly uncorrelated assets became correlated -- meaning nearly everything went down at the same time. (Except the longest-dated Treasurys. Fear flooded that market with cash, allowing the bonds to return more than 20 percent in 2008. In other words, investors were willing to pay 120 bucks for a $100 bond).

"We were banging the drum on counter-party risk a year ago and no one cared," says Keith McCullough, chief executive of ResearchEdge, a New Haven, Conn., research outfit. "The entire world never worried about it until it was too late."

By mid-February of 2009 total panic gripped the market. On a technical and fundamental basis, the market was broken. Forecasts for Dow 5,000 and S&P 500 were no longer seemingly crackpot calls. Heck, both indexes came way too close for comfort. The S&P notched an intraday low of 666 (the Sign of the Bear, er, Beast) on March 6 and the elusive bottom (fingers crossed) was presumably found.

Which brings us to Greed. Steve Scruggs, portfolio manager of Queens Road Small Cap Value fund (QRSVX), was a hero in the mutual fund world in 2008, having lost only 24 percent that year. He's a hardcore value investor. He bought a lot of stuff on the cheap in February and March, booked the gains, and is now back to holding about 20 percent cash.

That's because the market's remarkable 50 percent rally off the March low is being driven by faith or greed, not fundamentals. Market pros are riding price momentum, buying high and selling higher in order to recoup last year's losses as quickly as possible, he says. After all, missing a benchmark in a meltdown is less likely to get a fund manager fired than missing it on the way back up.

And let's also not forget the accounting changes that prettified the toxic balance sheets of so many of our most distressed financial institutions, Scruggs says.

"Fear came and went, but many of the same problems with the banking system remain," says Scruggs . "There's a lot of smoke and mirrors. We're making many of the same mistakes made during the S&L crisis and the Japanese malaise, which really just kicks the can down the road."

So where do we go from here? Wall Street's average price target for the S&P 500 by year's end stands at 1,022, according to Bloomberg, which is actually below where the market is now.

So be prepared for a range-bound market, at best. Equities are not particularly expensive by historical standards right now, but they're also by no means cheap.
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