(FORTUNE Magazine) – Investors have had a lot of their illusions shattered in the past few months. Not long ago everyone was convinced that globalization was always a good thing, that the little guy was in it for the long term, and that sugar water and razors would be recession-resistant businesses. But the illusion that has vanished quickest is the idea that big Wall Street brokerages had become stocks to hold for the long haul. Supposedly, the brokers had beefed up their risk-management capabilities, diversified, and stabilized their earnings streams, and would weather market downturns gracefully.

It's been anything but graceful. From the bigger and better to the smaller and less reputable, Wall Street stocks have plunged from their highs this July to shockingly low levels. Merrill Lynch fell from $108 to $44 at the end of the third quarter--down 59%. Morgan Stanley is down 59%; Bear Stearns, 53%; and Lehman Brothers, 67% (for more on Lehman, see the next story).

Part of the debacle can be blamed purely on the overall market rout, of course. But part of it is because investors overestimated the cushion that "steadier" sources of earnings would provide. "We'd been believing that the brokerage business had changed. This is a reminder that transactions still matter, a lot," says Rand Alexander, a large-cap equity manager for the Hartford.

But the main reason the brokers are getting crushed is that investors are scared silly. The collapse of that once celebrated hedge fund, Long Term Capital Management (see Carol Loomis' feature story in this issue), came as a grim thunderclap in the midst of the brokers' bad-news storm. Investors are terrified that the big Wall Street firms are as clueless as that gang from Greenwich.

Looking at their battered share prices, you may wonder whether now is the time to buy--since they're at price/earnings multiples not seen in years (Merrill, for example, now trades at 10.4 times 1998's reduced earnings estimate). But does the real pain still lie ahead? As Michael Weiner, director of equity research at Banc One Investment Advisors, asks, "Are the brokers on sale or for sale?" To answer that, you need to step back and try to figure out exactly what's gone wrong.

Some of the problems are quantifiable. The pandemic turmoil in emerging markets has caused firms to announce trading losses in the hundreds of millions. At the same time, the unrest has abruptly curtailed the feverish stock- and bond-underwriting business that had been flowing effortlessly to Wall Street's bottom line. According to Securities Data, disclosed underwriting fees fell 50% in the third quarter. In July analysts were predicting that brokerage earnings would be flat in the third quarter; by mid-September the consensus was a 32% decline, says First Call. One concrete sign that the smart money doesn't expect things to get better anytime soon came when Goldman Sachs shelved its planned IPO and warned that it expected a difficult fourth quarter.

If the market believed no more bad news was in store, these stocks would not have fallen so far. The real problem is with the risks that are unquantifiable. No one knows how much the brokers ultimately stand to lose with Long Term Capital, with other hedge funds that may be holding on for dear life, or in their proprietary portfolios. Ask analysts, fund managers, traders, or hedge fund folks how hard the brokers could be hit in a worst-case scenario, and you get the same response: "Don't know."

How low could the stocks go? Although they look cheap on a price-to-earnings basis, on a book-value basis Banc One's Weiner thinks they could slide another 50%. Jonathan Lee, a hedge fund manager at Hollister Asset Management, gauges bearish sentiment by the cost of put options, which provide protection if a stock craters. Right now, puts on the brokers cost three times more than usual.

Still, the possible returns in brokerage stocks are tantalizing: Even if it takes Merrill Lynch five years to get back to its July high, that equates to a 19.7% annual return. And, of course, there's the best-case scenario: The market recovers, and so do the stocks.

One thing's for sure--investors haven't been differentiating between the bad and the ugly. Morgan Stanley, which saw its net income decline 25% last quarter, is down almost as much as Lehman, which saw its net more than cut in half. On the Street, there's widespread agreement on this: If you choose to venture into these stocks, you have three choices: Morgan Stanley, Merrill Lynch, or Travelers (which owns Salomon Smith Barney). They are the powerhouses with big businesses in other areas like credit cards, insurance, and asset management. They should be strong enough to survive. And they will be first to recover.