INVESTING: Conditions are brutal, but opportunity awaits

The depths of the problems plaguing financial firms were on full display July 7, the date Fannie Mae’s shares dropped 16 percent and Freddie Mac’s tumbled 18 percent.

Last December in this column, I marveled at how well the stock market had absorbed a 25-percent nose dive in the stocks of these two mortgage titans during trading Nov. 20.

Since their highs last fall, these two institutions that underpin the mortgage and housing market have lost 75 percent of their value. Together, in the last nine months they’ve shed more than $80 billion in market value. The Federal Reserve and the Treasury both have urged Freddie and Fannie to raise additional capital from investors, a feat that has become increasingly difficult as their financial health has worsened.

U.S. financial firms collectively have lost more than $1 trillion in value this year. Jamie Dimon, chairman of JP Morgan, has suggested that while some credit market issues have been resolved-notably via his firm’s bailout of Bear Stearns-this does not mean market conditions could not get worse.

The Fed has stated that it expects the turmoil in the housing and financial markets to continue well into 2009. As such, Fed Chairman Ben Bernanke plans to keep the window open to investment banks to access direct loans from the central bank. In return for this lifeline, the Fed and the Securities and Exchange Commission will gain more oversight of investment banks’ capital, liquidity and funding arrangements.

For investors, the obstacles preventing successful navigation in this investing environment appear to be overwhelming. Yet when things look the worst, there will be opportunity. The great investor Sir John Templeton-who died this month at the age of 95-maintained that a key principle investors should remember is that the point of “maximum pessimism” in the market is the best time to buy stocks.

Whether we are at that point today in investor sentiment is difficult to say, with the market down about 20 percent from the high reached last October. Some pundits argue a bottom will be reached only when people no longer want anything to do with stocks. However, one thing you can count on is that stocks will turn upward well before there are clear signs of a business recovery.

Recently, I looked at a chart of the stock market back in the bleak years of 1973-1974. Of course, the economic environment was somewhat different than it is today, but investor behavior in such periods can be similar.

On Jan. 2, 1973, the Dow Jones industrial average peaked at 1047. Over the next 17 months, the market trended down about 15 percent. Then, in a final capitulation, it fell another 30 percent over the summer, as investors abandoned stocks in droves.

The Dow then bounced around 580, seeking a bottom the last three months of 1974. That November, Forbes published an article written by a little-known investor named Warren Buffett. Here, at the nadir in the stock market, Buffett proclaimed it was “time to invest and get rich.” I anticipate that investors may once again have such an opportunity, but in the near term I suspect we’ll go through more hand-wringing.