GOOD MEDICINE FOR THE MARKETS

What to make of the current market volatility? Is it a sign the bull market is finally over and a bear market is to follow? Or is it merely the pause that refreshes?

Probably the latter. The loss of almost 700 points since July may, in fact, have forestalled a bear market — or worse. But that depends on what the Federal Reserve Board, investors and consumers do in the next month or two.

There are several reasons for optimism.

First, the summer correction appears to have cooled investor enthusiasm, which had pushed equity prices too far too fast, certainly well ahead of corporate earnings growth.

Second, it may have reduced consumer confidence just enough to cut excessive spending that fueled strong gross domestic product growth in the first quarter, and faster-than-expected growth in the second quarter, back to more acceptable levels.

Third, it allowed the Federal Reserve to stand pat last Tuesday and not raise interest rates. No small matter. The Fed is walking a tightrope between preventing a resurgence of inflation in the United States and accommodating the recovery of the Asian nations from their severe recession.

An inopportune interest rate increase, forced on the Fed by an economy threatening to overheat, could be devastating not only for the U.S. stock market, already nervous about earnings prospects, but for the rest of the world.

The global economy is teetering on the brink, and a wrong move by the Fed could push it over the edge into a worldwide recession, and even depression in many countries.

How? In much the same way it did in 1928-29 when Fed-engineered rate increases helped trigger the stock market collapse that sparked the Great Depression.

A meaningful rate increase — 50 basis points or so — would knock the props out from under the stock market, causing a much more dramatic drop than seen in the past few weeks. Individual investors, who have been steadfast so far, might begin pulling back on their equity fund holdings. Mutual fund and stock prices could plunge.

The impact on ordinary investors would be enormous — equivalent to the 1929-30 bank failures — because so much of their savings is now in mutual funds. Spending would dry up. The U.S. economy, the engine of the world at present, would grind almost to a halt, out of steam. Other economies, relying on the U.S. for power, would collapse as exports dried up.

This scenario is what the summer correction at least postponed, and may have headed off, by taking pressure off the Fed. There may be more such volatility in the months ahead. It may be uncomfortable and nerve-wracking in the short run, but it may save investors much pain in the long run. It’s worth reminding them of that — and that volatility is the reason equity investors on average receive higher returns in the long run than bond investors.