The Dangerous Mistake to Avoid Now

Over the next few weeks, you'll hear a lot about the opportunities presented by the market's recent volatility. While the market is only a bit off its highs, many stocks have been obliterated. And we're not talking small, high-risk companies.

Just look at some of these names:

Stock

52-Week High

Recent Price

Change

Ambac Financial (NYSE:ABK)

$96.10

$22.81

(76%)

D.R. Horton (NYSE:DHI)

$31.13

$13.31

(57%)

E*Trade Financial (NASDAQ:ETFC)

$26.08

$3.87

(85%)

Health Management Associates* (NYSE:HMA)           

$21.59

$15.92 

(26%)

IndyMac Bancorp (NYSE:IMB)

$46.50

$6.15  

(87%)

MBIA (NYSE:MBI)                

$76.02

$19.65

(74%)

Washington Mutual (NYSE:WM)    

$46.38

$15.15

(67%)

*Includes special $10 dividend.

These are some of the biggest stocks on the market -- MBIA has a triple-A credit rating! Yet, on average, these companies are down 67% from their 52-week highs. That's unfortunate for existing shareholders, but consider the opportunity it presents for us.

If these stocks just return to their highs, your average return would be 300%!

The horrible mistake
But this sort of simplistic reasoning can quickly cause trouble -- it's based upon the price of the shares rather than the value of the businesses. It's totally unclear from looking at charts whether a stock's 52-week-high price had anything to do with actual value of the underlying company.

Perhaps speculation affected the share price, and at the 52-week high, shares were way overvalued. Or maybe the business has deteriorated significantly since its high, and its value has fallen. In that case, it would be unreasonable to expect the shares to return to their highs any time soon.

For instance, when Washington Mutual and IndyMac were trading at their highs some 12 months ago, many people had begun to recognize that the real estate market was slowing. Washington Mutual and IndyMac were priced assuming that the market would slow a bit, but not crash. However, since then, the true extent of the problem has become evident.

Meet "evident"
In the past few years, most banks relaxed their lending standards. Because they were planning to sell loans almost as soon as they lent the money, it was no skin off their nose if they gave mortgages to people who couldn't actually afford the payments. The banks would get their quick profits from selling the loan and move on to the next deal. So they lent money to anyone who could fog a mirror.

One could argue that it was a rational -- if unethical -- strategy for banks. The banks would show income. Management would collect hefty bonuses on this fake income. And Alan Greenspan made it clear throughout his tenure that if any big problems arose, the government and taxpayers would be happy to bail out the losers.

Welcome back, chickens!
But now those chickens have come home to roost, and Washington Mutual and IndyMac have to deal with the fallout. You can't value these companies based on the environment of a year ago. Both housing prices and sales are falling. Lending standards have also tightened, meaning it's much more difficult to sell a loan today than it was last year.

So even if Washington Mutual waved a magic wand and got rid of all its exposure to bad debt, the market isn't the same place it was a year ago. It could be decades before we see another housing market as hot as it was the past few years, so it's completely unreasonable to consider Washington Mutual's earnings during that period as indicative of how it will perform in a sane environment.

In other words, these companies need to be valued on today's fundamentals ... not yesterday's.

The Foolish bottom line
That's not to say that you shouldn't look for purchases among the stocks that have been slaughtered. You can find some truly amazing bargains when people are selling in a panic, as they are now. But don't base your buys on where a stock has been. Instead, analyze the business and buy it if it's cheap based on its future earnings.

And there are some amazing opportunities out there.

When talking about the current turmoil, Philip Durell, the advisor for our Motley Fool Inside Value investing service, noted, "In the time that I've been running the newsletter, I've never seen so many excellent companies trading at such cheap prices." It's just a matter of grabbing the right stocks and holding on for the ride.

If you're interested in seeing what Philip's talking about, we offer a 30-day free trial.

Fool contributor Richard Gibbons went to bed early and got up early, but still feels sickly, poor, and misguided. He does not have a position in any of the stocks discussed above. Washington Mutual is a Motley Fool Income Investor recommendation. The Fool disclosure policy is not always fuchsia.


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