The week of October 6 through October 10, 2008, saw a slow moving crash in the stock market. All the major indices declined by nearly 20%. For a full week, it was worse than the crash of October 1987.

So investors are left trying to decide where to go from here. The world always looks different right after a crisis, or crash. For some, they will always be convinced that there is more pain to come. But is a market that has declined more than 45% in just less than a year fairly valued?

It would be fairly valued if a depression was forming. As I wrote just last week there is nowhere near the dislocation in the banking system and economy to cause a depression. So, as markets ALWAYS do, they overshoot equilibrium. During bull markets they always drive to ridiculously high valuations (think dot-coms and real estate) and during bear markets there is panic that takes stocks to unthinkably low levels.

There is plenty of evidence that the bottom has been reached, aside from the panic itself, mostly behind the scenes in the financial system. The media, and every politician, has been spinning the panic as an end-of-the-world event to keep viewers/voters attention, yet most talking heads wouldn’t know a credit derivative from a default swap.

Those two securities are at the heart of the panic. In brief, it was mortgage loans, tranched into derivatives, and coupled with default swaps that constituted this mess. Since derivative contracts are booked on contract value, not notional value, the total dollar amount of these securities ballooned to $64 trillion. Problem was, there was no liquid market to price them. Instead, their values were calculated using ultra-complex formulas with stale assumptions. Once the assumptions were proven wrong, valuations had to decline.

Because accounting rules require financial institutions to write down the value of assets that are more than temporarily impaired, banks and brokers began to write down the value of their mortgage-backed derivatives, and began to call for payoffs from their default swaps. But those write-downs were nothing more than guesses, or in some cases fantasy. The cascade of guesswork created more impaired assets and the cycle continued to spiral downward.

Throughout the crisis banks have been leery of lending to one another for fear of each institution’s potential bankruptcy from all the losses. Since no one entity could get a handle on the pricing of these assets, no one knew the total extent of the damage. And so the crisis grew.

The panic of 2008 (or the Crash of 2008) was caused, for the most part, by institutional investors preparing for full knowledge by raising cash. When Lehman Brothers was allowed to fail and declare bankruptcy the stage was set for the light to finally shine on these hard to value assets. To settle debts in bankruptcy, the bankrupt institution has to sell assets and value itself. So, beginning October 10, 2008, Lehman’s derivative assets are being valued through real trades, not complex formulas.

In response to the potential repricing of derivatives from the Lehman bankruptcy, financial institutions around the world struggled to raise cash and equity. That rush of asset sales created the conditions for the panic. Once the overwhelming selling pressure snowballed to smaller investors, the mentality became “sell at any price”.

Again, as we re-evaluate things after the crash, where are we with regard to the Lehman bankruptcy? From all relevant data, while it looks bad, it is nowhere near the catastrophe many projected, including central banks the world over. The bailouts and cash infusions were a direct result of fear from central bankers that the derivative repricing would ruin the entire system. And that fear was transferred to smaller investors who began to question the health of the entire banking system.

Now that the fear has ebbed, and the financial system is still functioning, is a depression scenario more or less likely? It seems that since the Lehman Brothers bankruptcy will provide the one thing that could have ended this mess last year, full knowledge of losses, the financial system may now have a good handle on just how bad the crisis is. That knowledge, more than any bailout, will begin restoring confidence in the system and return it to normal functioning.

How will stock investors react to that knowledge? When the financial system actually survives this crisis will investors be more likely to sell everything again, or maybe begin thinking about buying companies at fire sale prices?

One issue is more certain. The fact that institutions were raising cash at any price shows that they were preparing for a worst-case scenario. Anything less than a worst-case will, at the very least, stop their selling.

Without the institutional selling pressure, it is hard to see the market reaching 50% on the downside. And the fire-sale prices will attract more than a few investors who kept their heads during the Panic of 2008.

Jeffrey P. Snider is Vice President and Portfolio Manager for Atlantic Capital Management. For more economic and market analysis sample our research at http://www.client-centered.net

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