Your best moves in a crazy market

Despite an early surge in stocks on Friday, volatility will likely rule. How to position yourself for the long term.

By Michael Sivy, Money Magazine editor at large

NEW YORK (Money) -- Stocks surged early Friday, following the Federal Reserve's cut in the discount rate. But the major indexes have given back some of those gains. And investors are still wondering whether the stock market correction is nearing an end or is going to get worse.

The short answer is that the market turmoil probably isn't over. But there is some good news, too. This has been a moderately serious correction, but it's not as dangerous as some past selloffs, and over the next couple of years it actually could be beneficial for the prices of top-quality shares.

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The Fed's action this morning cuts both ways. If Chairman Bernanke simply wanted to flood the banking system with cheap money, he would have lowered the Federal Funds rate.

Lowering the discount rate has a slightly different effect. Essentially, it guarantees that banks will have access to credit at a reasonable price, and it thereby prevents a credit crunch. Such a rate cut shows that the Fed is worried about the economy, yet it doesn't make money as cheap as a Fed Funds rate cut would.

The good news is that Bernanke has shown that he's going to act to prevent more deeply serious problems. The not-so-good news is that investors aren't going to get the rate reductions they would like. And the factors that have caused the market turmoil are continuing.

Here's a look at the key points of this market correction, in Q&A form, including some of the specific questions we have received from Money Magazine readers.

1) Why has this happened?

There are essentially three possible reasons for a major decline in stock prices. The most common is that the economy goes into recession.

The second is a collapse in valuations. When unrestrained investor enthusiasm bids share prices up to very high levels, a relatively minor disappointment can trigger a sharp drop in price/earnings ratios. That's what happened when growth stocks plummeted at the end of the tech boom - P/Es of more than 30 dropped to less than 20.

The least common reason for a major market drop is a credit crunch. This used to be caused by a string of bank failures. But in today's high-tech economy, it's more likely the result of some sophisticated financial products blowing up. The current debacle is the result of complex mortgage-backed securities that encouraged excessive lending. And once the housing market started to decline, many marginal mortgage loans got into trouble.

2) How bad are things?

It's hard to say and sometimes even the lenders themselves don't know.

There are a few things we do know, however. The decline hasn't been as sharp as it was during the 1987 Crash. The damage to financial stocks isn't as bad as it was in 1990, when the magnitude of the Savings and Loan Crisis became evident. And the market decline hasn't been as broad as the bear market of 2000-2002.

3) Why are stock prices so volatile?

Professional investors are the chief factors in the current selloff. Trading desks, hedge funds and private equity use a great deal of leverage - they borrow a lot and depend on aggressive margin trading to maximize their profits. As a result, they are extremely vulnerable to any constriction in the supply of credit.

If the market starts heading down, margin calls may force these pros to sell, even if they don't want to. And modern computerized trading can result in a cascade effect.

Margin calls make traders dump stocks, which drives share prices down so much that another round of margin calls is triggered. Portfolio managers may have to sell whatever they can move in volume. So paradoxically, better-quality, liquid stocks may actually be the ones that are dumped.

Other professional traders may try to profit from such market declines by selling short. They typically reduce their short exposure by purchasing stock in the last hour before the market closes. That can produce a whipsaw, like the one we saw on Thursday, where stocks plunge and then rally back powerfully at the end of the day.

4) Will there be a recession?

It's possible - despite the Fed's rate cut, there still may be a one-in-three chance of recession. But it's more likely that the economy will keep growing, although at a slower rate.

Many sectors are little affected by the mortgage crisis. Unemployment is low. And the Federal Reserve will probably continue to inject money into the banking system to prevent a credit crunch.

5) Can I do anything to protect my investments?

As always, it turns out that complex risk-management strategies can't protect you consistently, while basic diversification usually works best. But diversification needs to be in place before the shocks hit - there's little you can do while a crisis is actually going on.

6) Will real estate prices be affected?

They already have been, of course. In the most overheated real estate markets - particularly in parts of South Florida, Las Vegas and Southern California - home prices are down sharply.

It's also generally true that bear markets in real estate take a long time to unfold fully. So prices could trend down in some markets for a couple of years.

7) Is there any way to profit from this?

In a credit crunch, cash is king. People with uninvested money and those who regularly put away part of their salary will have plenty of opportunities to take advantage of opportunities - both in the stock market and the real estate market - as they become available.

There's one important caveat, though. Don't rush to snatch bargains the minute you see them developing. Once a major market decline begins, it often continues for more than six months. And stock prices can remain relatively flat for months longer.

Now is the time to be planning the optimum diversification for your long-term investments and developing the buy list that will reposition your portfolio the way you want it. Then follow the stocks on your buy list but move slowly in adding them to your holdings. Sivy 70: America's best stocks

In the long run, though, this strategy can pay off. Just consider that after each of the last three major selloffs ended, the Dow climbed a minimum of 32 percent over the following two years. Top of page