Right now, things look bad. Every day, the economic news looks worse. Unemployment has been creeping up. The service sector is shrinking for the first time in half a decade. Consumer confidence is declining.

The stock market's performance of late reflects this news. The S&P 500 is down about 6% year to date, and some stocks have been completely mauled. It's only April and Merck (NYSE: MRK), Qwest Communications (NYSE: Q), and MGM Mirage (NYSE: MGM) have already all been clobbered by more than 30%.

You might expect that sort of monthly volatility from small caps, but these are well-known companies that started the year with market caps of $10 billion or more.

Things look so bad that you might think there's nowhere to go but up. But I think this crisis has just begun.

An explosive situation
For months, we've been experiencing a liquidity crisis that has locked up credit markets. It's now apparent that the debt market was a disaster waiting to happen ... and that the collapsing housing market was all that was needed to end the wait.

The problem is, if you look at the catalyst for this crash, you'll see that the correction may have just begun. As of November, housing was 8.4% off its peak. That's right, a mere 8.4% decline has caused financials to melt down, homebuilders to go bankrupt, and the panicked Federal Reserve to ignore its inflation-fighting mandate and push through interest-rate cuts -- despite the highest inflation rates since 1990.

But how bad could it get? Well, Goldman Sachs -- noteworthy for being the one big investment bank that was smart enough not to get burned by securitized mortgages -- has predicted that if there's no recession, the housing market will probably fall by 15%. If there is a recession, Goldman thinks prices could fall by 30%. That's a heck of a lot more than the current 8.4% decline.  

A negative equity landslide
And if housing continues to fall, the problems will only get worse. For instance, you may have heard of people with negative equity in their homes walking away from their houses and their mortgages. If you owe more on your house than it's worth, deliberately pursuing foreclosure can be a rational -- if unethical -- decision. It isn't surprising that this is happening. For years, lenders have been using legal fine print to gouge borrowers by raising the interest rates on credit cards and charging obscure fees seemingly whenever the mood struck them. Borrowers are now playing the same game, taking advantage of legal loopholes to dodge their debts.

But this is happening with only an 8.4% fall in the housing market. What happens with a 15% or 30% fall?

For the mortgage industry, it's more than a rhetorical question. Using data from December 2006, First American calculated how many homeowners would be under water if house prices started falling. The numbers are startling.

Total % Decline in Housing

% Mortgages With Negative Equity

8.4% (Today)       


15.0% (No Recession)       


30.0% (Recession)


So, using Goldman's 15% estimated decline, 21% of people with mortgages would owe more money than their house is actually worth. If a recession develops -- which, frankly, seems likely to me -- and the market falls 30%, then nearly two of every five mortgages would be under water.

A vicious cycle?
In light of those numbers, it's not so surprising that the Fed is panicking. Default could make sense financially for a huge number of people, and if there's negative equity, lenders will have lost money, even before you consider the high costs of foreclosure. What's more, since lenders are generally highly leveraged, moving from a manageable 1% to 2% default rate to a 5% to 6% default rate can destroy capital adequacy ratios at an increasing rate. This will reduce the liquidity in the mortgage market, making it harder for housing sales to improve.

And again, this crisis may have only just begun. The average foreclosure in a good market takes a little more than 10 months, according to a research paper from the Federal Reserve Bank of St. Louis. So, we've only begun ironing out the foreclosures resulting from the credit crunch that started over the summer. The impact on the economy won't just be the direct effect of the loss of lending, real estate, and construction jobs. As consumers' equity in their homes falls, it means that they can no longer borrow against that equity to buy consumer goods.

This may sound like a small problem, but this borrowing has been helping our economy grow. In recent years, it's been estimated to be equal to 6% to 8% of consumers' disposable income. If the economy has slowed this much when consumers continue to have some spending power, how bad will it get if they have to stop spending completely?

What investors should do
I don't think you should panic, but at times like these, you should be very aware of what's in your portfolio. Moving entirely to cash isn't the right strategy, because then you'll miss out on the bottom and what will be the best buying opportunity in the next decade. Instead, make sure that your portfolio is completely solid.

Overvalued story stocks are not going to cut it in this market. For example, in early January, I warned against buying overheated solar power companies. Since then, two of the companies I cautioned against buying, SunPower and Suntech Power (NYSE: STP), are down 31% and 44%, respectively. In the interest of full disclosure, the third company I warned against (First Solar) is up about 7%, but in my mind that merely makes the stock more dangerous. Grossly overvalued stocks have no margin of safety, so in a panicky market, there's absolutely nothing to support their stock prices.

Instead, focus on stocks that are trading for less than their fair value. Such stocks have a margin of safety and therefore tend to find support even in bad times. What's more, cheap stocks are often cheap precisely because people are expecting bad news. As a result, any bad news tends to have little effect, while good news causes a jump. So, when the market turns, you can sometimes make money in these stocks extremely quickly.

In fact, that's the one good thing about this market. There are some stocks that are now unbelievably cheap, and these stocks could have fantastic returns in the next few years. For example, I think both UPS (NYSE: UPS) and FedEx (NYSE: FDX) have been punished excessively and look cheap at these levels.

The Foolish bottom line
Be extremely cautious in this market, but keep looking for opportunities. Position your portfolio in undervalued stocks to reduce your risk and give you potentially huge gains when the market finally turns.

If you're looking for help identifying unbelievably cheap stocks, our Inside Value newsletter recommends a slew of stocks that are currently trading at prices below their intrinsic value. You can read all about them with a free trial.

This article was first published March 3, 2008. It has been updated.

Fool contributor Richard Gibbons thinks Alan Greenspan deserves a lot of credit for this lovely situation. Richard does not have a position in any of the stocks in this article. First American is an Inside Value pick. FedEx is a Stock Advisor recommendation. UPS is an Income Investor pick. Suntech Power is a Rule Breakers selection. The Fool has a disclosure policy.