Crazy, stupid, or both?
We know Mr. Market is manic, but is he also a complete moron?

It's a question worth pondering after yesterday's roller-coaster ride. Early in the day, headline after headline told us (convincingly, for once, I believe) that shares were being pounded pending an expected decision from the Fed to keep interest rates where they stand. By the end of the day, nearly everything on my screen was flashing green, and the new logic was something along the lines of "Fed's continued firmness on rates persuades investors that the economy is fine."

In other words, that free-money injection isn't coming, but let's party anyway. That looks both crazy and stupid to me. Here's why.

Look back into madness
Peer over your shoulder and get a glimpse of what I'm talking about. Stocks have been on a wild ride for weeks now, as worries about a credit crunch have finally caused investors and businesses to pay attention to the real cost of risk. It all started, of course, with subprime loans, which turned out to be as toxic as many of us had been warning. The contagion next moved into so-called "Alt-A" lending, infamous now as "liars' loans." That seems to have accelerated the stampede away from all those sliced-and-diced, mortgage-backed securities with creative names, and similar debt instruments. You know, the brainiac-designed debt pools that enabled all those lousy loans, then masqueraded as sure and safe money to those who were purchasing them over the past few years. Until the whole safe part turned out not to be true.

As defaults went up, the credit-worthiness of these Frankenstein's monsters came into question, with the result that the buyers of those instruments dried up, and the sellers coped with the double potential problem of selling at fire-sale rates or holding them and marking them down. The whole housing Ponzi scheme started to crumble. Then, predictably, the virus seems to have mutated, jumping out of housing, and sickening an ever-widening swath of the economy, and forcing a somber -- if years-too-late -- reassessment.

The financiers seem to have finally asked themselves, "If American consumers who've been flipping up the home ladder, and taking out option-ARMs so they could buy McMansions from Toll Brothers (NYSE:TOL), as well as tapping home equity lines of credit to fill them with flat-screen TVs from Syntax-Brillian, $200 True Religion jeans for the teens, Sub-Zero fridges, giant GM suck-Vees, Heelys, and iPods ... if they can't be trusted to make good on their mortgage payments, who else is going to welsh on their debts? Maybe the folks selling all that stuff?"


"And maybe we shouldn't lend so cheap and easy," they have realized.

The fallout
The reaction has been swift and painful. The Economist and other news outlets have reported the new demise of lending on "covenant lite" or "payment-in-kind" bases (forms of debt that restricted lender oversight of the borrowing companies, or let them pay their debt with yet more IOUs). And I've seen stories suggesting that, in sum, hundreds of billions of dollars worth of financing assumed to be coming to market may now just never happen. (Why else do you think Fortress Investment Group (NYSE:FIG) and Blackstone (NYSE:BX) went public weeks back? Ever hear of getting out while the gettin' is good?)

Broadly speaking, the result is that companies who depend on debt -- either issuing it, reselling it, trading it, investing for its yields, or borrowing to boost per-share earnings -- are feeling the pain. So, it's not just mortgage industry mess-makers like hedge-fund loser Bear Stearns (NYSE:BSC), going-down-swinging Impac Mortgage Holdings (NYSE:IMH), or dead-fish American Home Mortgage (NYSE:AHM) that have been punished. Everything from retail to consumer goods has been hammered as the Street wonders whether a housing bust will lead to profit-sapping cuts in consumer spending.

The pitiful pleas
It's no secret that Realtors, traders, and other get-rich-quick dreamers have been begging the Fed to reopen the spigots and flood the economy with another dose of cheap money. They've been doing it for a while, because their paychecks depended on it. But now this crowd is reaching a stage so desperate it's funny. Witness Jim Cramer screaming his fool head off to try and get Ben Bernanke to rescue his poor, pitiable Wall Street buddies -- guys who made millions in personal profits from the great Housing Ponzi scheme -- simply because they may now have to go without an ivory backscratcher or two because their schemes have gone sour.

Let me be very clear about what I think should happen in response to this calamity: The Fed shouldn't even waggle an eyebrow, because another dose of free money would be bad medicine, and it would only prolong and intensify the eventual hangover. Inflation, even outside the jumpy commodities that the Fed likes to ignore, is a serious risk to the U.S. and world economies, and it's clear from the heady price increases, and stagnating productivity in the U.S., that there's still plenty of money chasing goods and services of all kinds. Until that money dries up, the risks remain.

(And if a few of Jim Cramer's investment banking or hedge fund buddies have to do without the eight-figure bonus this year, too bad.)

Believing what you want
Enter the Fed and chief Bernanke, who's no longer living up to his moniker, "helicopter Ben." Look at what the Fed tried to tell the markets yesterday: Inflation is job one. We're not coming to the rescue of the housing or credit markets. Yet somehow, Mr. Market didn't read the writing on the wall, and saw only what it wanted: The economy is fine! Time to get back to the party!

Even if the Fed does believe the economy is fine, and even if it's correct (I'm of the opinion that underlying business prospects are pretty sound), that certainly doesn't mean stocks are priced reasonably. Something like Home Depot (NYSE:HD) for instance, is relying on a giant share buyback as its fortunes dwindle in the housing crunch, and using borrowed money to boost per-share earnings is something that an enormous number of companies have been doing these days. Take away some revenue growth, watch margins slip through de-levering, and stop the share-count sop-ups, and you'll see earnings growth slow, stop, or hit reverse at many companies. And when that happens, share prices follow.

Believe this
There's not much you can do to escape completely the manias and moronic moods of Mr. Market. But you can mitigate short-term damage and outperform in the long run by picking your individual companies carefully, and doing what Mr. Credit Market didn't: Make sure potential rewards adequately compensate you for your risks.

Home Depot is a Motley Fool Inside Value recommendation.

At the time of publication, Seth Jayson, a top-10 CAPS player, wondered why he was still holding shares of Home Depot, but he had no positions in any other company mentioned here. See his latest CAPS blog commentary here. View his stock holdings and Fool profile here. Fool rules are here.