OK the world isn't ending

But what has to go right for stocks to rebound?

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By Michael Sivy, Money Magazine editor-at-large

The recent real estate bubble in the U.S., however, never got as overinflated as the one in Japan did. And although the Fed and other parts of the government are trying to cushion the fall, they aren't trying to postpone it indefinitely. U.S. banks, unlike their Japanese counterparts of the '90s, tend to acknowledge loan losses fairly promptly. That may hurt stocks in the short run, but it should leave the economy and the market open for a recovery much sooner.

The stock market always recovers from setbacks, if you're prepared to wait long enough. The real question is what's needed for a prompt recovery. The average bear market lasts 14 months, but declines can end in less than six months if the economy doesn't suffer an extended slump - and if share prices are not massively overvalued to begin with.

On this second point, the numbers are encouraging. The most popular blue chips were trading at price/earnings ratios above 30 back in 2000, right before growth stocks collapsed. The historical average for those stocks is 24, and they were at less than 20 when the market topped last October.

As for how big a decline might be, past bear markets have split into two categories: those in which blue chips drop by an average of 22% and much bigger declines in which the drop averages 39%. The S&P 500 has been down as much as 18% from its October high, so I don't expect much more downside.

That said, my optimistic outlook for stocks does rest on two reasonable, though by no means surefire, assumptions. The first is that the Fed will pursue the right interest-rate policy - specifically, that it will continue to cut short-term rates this year and that it will also start nudging them back up in a year or two so that the economy and inflation don't over-heat.

That's not as easy as it sounds. A big part of the blame for the current troubles can be laid at the feet of the Greenspan Fed, which in hindsight kept rates too low for too long following 9/11 and ended up pumping more and more hot air into the real estate bubble.

The second assumption is that the scale of loan losses will remain within manageable bounds. The doomsayers notwithstanding, the total equity in the U.S. financial system is many times larger than the total losses most economists expect.

But what about the dollar? If it keeps dropping, that has to be bad, no?

" The dollar normally declines when the U.S. runs a very big budget deficit and the economy slows, especially if similar trends aren't occurring in countries that we trade with. Even more important is the level of interest rates. Europe hasn't been cutting rates much, while the Fed has slashed ours by three percentage points in less than a year. Foreigners don't want investments in declining dollars when their interest income is also falling.

A weak dollar is inconvenient if you travel overseas, and it pushes up the prices of imports. But the weakness also makes U.S. products cheaper for foreigners and helps U.S. exports. Many U.S.-based multinational companies get more than 40% of their earnings from outside the country. At the very least, export growth saves jobs and helps lessen the impact of a recession.

In any event, the Fed can't afford to worry about the dollar as long as it has the credit crunch to deal with. Low interest rates are necessary to limit damage to the economy which has to be top priority. When growth resumes and the Fed is raising rates once again, the dollar should recover much of its lost value.

What should I be doing with my portfolio?

You can't buy low and sell high if you dump stocks in a depressed market. Today lots of blue chips trading at below-average P/Es are likely to be bargains. When you're considering such stocks, start by looking at businesses that get a large share of earnings overseas, where economies are more stable now.

Low debt is always good. So is a dividend yield of more than 2.5%. The blue chips mentioned in our 100 best list share these characteristics. If you prefer mutual funds, dollar-cost averaging into a total stock market mutual fund or investing in a high-yield stock fund makes sense psychologically and financially in this market.

Beyond that, follow the rules of investing that apply in any market. Diversify your investments as broadly as possible, minimize your trading costs, and balance growth stocks with income investments.

What if things do go wrong?

If you buy into the dire outlook that Roubini sees, you might want to take all your money and put it into Treasury bonds or CDs and wait things out. The problem with that strategy is that you not only have to be right in your pessimism, you have to know exactly when to turn optimistic again. Even the experts have a hard time getting that right.

And it's worth noting that Roubini, despite his concerns about the next few years, keeps his entire portfolio in stocks because he sees himself as a long-term investor.

But if you feel like you must do something, there are more reasonable insurance strategies you can employ. Increase the size of your emergency cash fund. Put a small slice of your portfolio into an inflation hedge like T. Rowe Price's New Era fund, which invests in commodity producers. Invest in foreign blue-chip mutual funds to hedge against a falling dollar.

For my money, this insurance is too expensive now. Commodity and foreign-stock funds have already had a big run, and those are the areas of the market where investors have been piling in lately. Historically, following the crowd only leaves you poorer. I'd rather pick up bargains among the strongest U.S. stocks. That would let me rest easier at night.

- Reporting By Joe Light; Donna Rosato contributed to this article. To top of page

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