The Wall Street Panic of 2008

Panic: in economics, acute financial disturbance, such as widespread bank failures, feverish stock speculation followed by a market crash, or a climate of fear caused by economic crisis or the anticipation of such crisis.
-- Britannica Online

Make no mistake -- by this definition, 2008 was nothing less than a global market panic -- and it may not be over yet.

Acute financial disturbance? Freddie Mac and Fannie Mae imploded. Bear Stearns got "rescued" along with AIG, but somehow Lehman Brothers wasn't saved. Our country's top banks like Bank of America and US Bancorp (NYSE:USB) were fed government bailout funds. The last two stand-alone investment banks on Wall Street, Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), fled for relief by becoming bank holding companies.

Feverish speculation followed by a crash? Our housing bubble fueled excessive borrowing and risky lending practices, resulting in the credit crisis we're now dealing with. The S&P 500 fell 38%, erasing the past six years of market gains.

Climate of fear? The private sector shed 693,000 jobs in December alone, U.S. consumer sentiment remains at record lows, and the CBOE Volatility Index (the "fear index") still shows significant market uncertainty.

The list, sadly, could go on.

Don't panic
Of course, no one wants to call this a market "panic." Instead, in most places it's been labeled a "crisis." In fact, the term "panic" hasn't been widely used to describe a market since the Panic of 1907 -- which is unfortunate, because understanding this as a panic has something to teach us.

In the 19th century (the high time for market panics), Yale professor William Graham Sumner defined a panic as "a wave of emotion, apprehension, alarm. It is more or less irrational. It is superinduced upon a crisis, which is real and inevitable, but it exaggerates, conjures up possibilities, takes away courage and energy."

In other words, the subprime and credit mess is the "crisis," and the "panic" is the exaggerations and doom-and-gloom language that come with it. We've seen plenty of that in recent months on network news and other financial media. So please, let's call this market by its proper name: a full-fledged panic.

Fortunately, "a panic," Sumner continued, "can be partly overcome by judicious reflection, by realization of the truth, and by measurement of facts."

Let us be judiciously reflective
So, what do the panics of the early 20th century tell us about how we might overcome this one?

The last official panic -- the Panic of 1907 -- shook the U.S. economy to its core. Wall Street brokerages failed, depositors ran on banks, well-known companies went under, and the market's liquidity was in question. (Sound familiar?) In this instance, J.P. Morgan and friends famously put together $25 million to keep the market afloat -- a role now occupied by the Federal Reserve. By 1909, the Dow Jones index had more than recovered from pre-panic highs.

In 1914, the year the Great War began in Europe, the U.S. stock markets actually closed for nearly four months after foreign investors began pulling their money out of U.S. equities en masse to support the war effort. When it reopened, the market was devalued about 30%, but sustained rallies doubled that opening by the end of 1916.

Then, of course, came the Great Depression -- the single most important economic event in U.S. history -- which began with the Crash of 1929 and lasted arguably until the U.S. entered World War II in 1941. In 1932, unemployment hit 24.9%, and more than 9,000 banks failed during the 1930s. And there were no federally insured deposits until the Banking Act of 1933 created the FDIC, so when the bank failed, your money went with it. In fact, Wall Street's very future -- not to mention the economic model of capitalism -- was in question.

For those investors who had both the money and the courage to invest in the 1930s, it paid off. One man famously borrowed money to buy 104 U.S. stocks trading for less than $1 a share in 1939. Talk about investing at the point of maximum pessimism! Four years later, though, his money had quadrupled. His name, of course, was John Templeton.

OK, what's your point?
Judicious reflection, realization of the truth, and measurement of facts all say the same thing: We've seen bad markets before. And in every case, the point at which the market has turned irrational or overly pessimistic is precisely the time we long-term investors should have bought equities.

Despite the headlines proclaiming the next Great Depression, this is no Great Depression, but market conditions could still be rocky in the short run. This uncertainty plays right into the hands of the financial media, whose job is to attract readership by sensationalizing news events, and financial institutions, which are built on commissions and fees, want to keep money moving in and out in order to bulk up their own revenues. So both fan the flames of panic.

Individual investors like us do not have the advantage versus Wall Street when it comes to short-term trading, but we do have longer time horizons. Wall Street focuses on minutes, hours, and days, while we focus on years and decades. And that's what makes their panics a good time for us to buy.

Let's take the most modern example of market irrationality -- the dot-com bubble and subsequent burst -- and see what's happened to some quality names since the S&P 500 was near its low in September 2002.

Data provided by Capital IQ. Returns adjusted for dividends.

You didn't need to be a market genius to invest in these names in 2002. They were all well-known to both consumers and investors. All five had been beaten down considerably by the bear market, though, and that downturn presented investors with excellent opportunities to buy great companies at great prices.

Ironically enough, however, the third quarter of 2002 had the fewest equity-based mutual fund assets of the entire post-dot-com bust. Simply put, investors bailed on the market at exactly the wrong time.

It's still scary
Don't get me wrong -- some of the financial headlines we've seen over the past few months are downright frightening. But it's important not to join the panic. Instead, keep a long-term perspective on market panics, booms, crises, and everything in between. In this market, that means you should keep investing bit by bit, and make sure you're diversified.

At our Motley Fool Stock Advisor investing service, Fool co-founders Tom and David Gardner had a lot of success picking up great companies during the post-dot-com bust. Their long-term focus helped them add names like Amazon.com at a time when the market wanted nothing to do with them. Their picks are subsequently beating the market by 28 percentage points on average.

They're taking a similar approach now, and they count top brand names among their "best buys" right now. To see what else they're recommending, take a free, 30-day trial. Click here to get started -- there's no obligation to subscribe.

This article was originally published on Sept. 4, 2008. It has been updated.

Todd Wenning panics at the sight of clowns, but not much else. He does not own shares of any company mentioned. US Bancorp and Bank of America are Motley Fool Income Investor picks. Amazon.com is a Motley Fool Stock Advisor recommendation. The Fool's disclosure policy keeps a steady hand.