WALL STREET: THE WILD DAY AFTER : Experts Split on What to Do With Stocks : Questions About Market, Taxes, Alternative Investments Answered

Why did stocks plummet? What can you do about it?

Here are some common questions--and answers--to help you understand what has been happening in the markets:

Question: Why did stocks collapse?

Answer: The biggest reason for Monday’s debacle was pure panic and fear. Investors, nervous in the wake of last Friday’s first 100-plus-point drop in the Dow Jones industrial average, stampeded to sell on Monday. Selling begat selling; investors tried to bail out before their stocks could decline even further.

Behind the emotions were pent-up concerns about higher interest rates, higher inflation, the Reagan Administration’s inability to significantly reduce trade and budget deficits and fears of rising tensions in the Middle East.

Also adding to Monday’s free-fall were computerized “program trading” strategies by big institutional investors, who sold millions of dollars in stocks instantaneously at the instructions of their computer programs.

Also, many experts say, the market had become overvalued during the five-year bull market that began in August, 1982. Since then, the Dow average has more than tripled in value. A serious correction--if not outright bear market--was overdue, they say.

Q: Does this mean that the bull market is over?

A: Probably, although there still are some die-hard bulls who say stocks will move to new highs next year.

But bears say that Monday’s free fall totally changed investor psychology and that investors will be much more conservative about investing in stocks. That could mean that it will take a long time for the Dow index to reach its Aug. 25 peak of 2,722.42.

Q: Does the stock decline mean a recession is coming?

A: If the decline is sustained, the chances are much stronger that a recession could begin in the next year or two. Monday’s plunge caused a reduction in wealth of about $500 billion, which--if not recovered--could reduce consumer and business spending and precipitate a recession much as the October, 1929, market crash preceded the Great Depression. Sustained stock collapses generally are followed by a recession.

Q: How does Monday’s crash compare to the 1929 crash?

A: Although Monday’s 22.61% drop in the Dow average exceeded the 12.82% fall on Oct. 28, 1929, many experts say this year’s debacle is less likely to lead to a depression on the same order of the Great Depression.

Among the differences: The economy is generally in better shape now than in 1929. Also, Uncle Sam is less likely to commit the same policy errors as in 1929, such as tightening the money supply.

Q: What will it take to bring on a rebound in stocks?

A: Many experts say it will take a sharp easing in interest rates and inflationary pressures, which probably will require action by the Federal Reserve Board. Also, they say, the dollar must stabilize, since a falling dollar adds pressure to rising interest rates and inflation.

The market may benefit from the Federal Reserve Board’s statement Tuesday that it would provide adequate funds to aid financial institutions hobbled by the stock collapse.

Q: Who are the biggest losers?

A: The biggest losers include those invested in blue-chip stocks, since these issues have fallen more than stocks of smaller companies. Other big losers include investors in mutual funds that borrowed to finance stock purchases.

The biggest individual loser may be Sam Walton, chairman and largest shareholder of Wal-Mart Stores. The value of his Wal-Mart stock plunged about $1 billion in Monday’s carnage.

Q: Who are the biggest winners?

A: The biggest winners include those who bought “put” options, which is the most profitable form of options trading during a market decline. Other winners include those who sold stocks short, also to profit from declining stock prices.

Others are those who simply sold their stocks about Aug. 25, when the Dow peaked. The Dow since then has lost about a third of its value.

Q: What should I do with my stocks?

A: Experts are divided on this. If you have not already sold your stocks, now may not be the best time to do so. The market may have already lost most of what it is going to lose.

If you are a long-term investor, sit tight and hold on until the market’s volatility wanes. But if you need cash for an emergency or big purchase, consider selling. But try to sell during rallies, not declines.

Q: What are the tax considerations if I sell now?

A: If you have owned your stock more than six months and have a gain, you will pay the long-term capital gains rate, which this year peaks at a top rate of 28%, contrasted with a top rate for ordinary income of 38.5%. So there may be some advantage in selling now. On the other hand, if you have a gain from a stock held less than six months, you may face a top rate of 38.5% this year versus only 33% next year.

If you have capital losses, you may deduct all of them, up to $3,000, from your short- or long-term capital gains.

Remember, however, that profits or losses on the stock can easily outweigh any tax implications.

Q: What stocks are likely to benefit in a bear market?

A: Generally, in a bear market, as many as 95% of all stocks go down. Stocks that tend to be hurt less in a decline are those with strong dividends, such as utilities.

One type of stock that defied Monday’s sell-off was gold mining stocks. They, like the metal itself, are seen as a hedge against inflation and hard times. However, these stocks are volatile and have not done as well as other stocks on a long-term basis.

Q: What is a margin call, and what should I do if I get one?

A: Yesterday’s free-fall means there is a chance you will get a margin call if you borrowed to pay for your stock. Margin calls are typically triggered when the amount of equity you have in a stock--the stock price minus the amount you borrowed--drops to 25% to 30% of the stock price.

Generally you have two options if you get a margin call: Sell the stock or pay your broker enough cash to cover the margin call.

Some experts say a margin call may be a good excuse to get out of the market now by selling rather than paying more cash. With the market’s rapid and violent swings, buying on margin has become riskier. Unless you are in the market primarily to gamble, most advisers say you should avoid buying on margin in the next few weeks.

Q: What should I do with my stock mutual funds?

A: You have some options: sitting tight, withdrawing your money or switching it into another fund. Some types of stock mutual funds, such as equity-income funds or growth-and-income funds, invest in stocks that pay dividends as well as provide opportunities for capital gains. They will tend to be less volatile than others. Some funds also are more flexible about holding a large portion of their assets as cash rather than stocks and thus will not rise as much in a bull market but will not fall as much in a bear.

One disadvantage of selling or switching in a rapidly tumbling market: The price of your fund shares are determined by the value of the fund’s portfolio at the close of that day’s trading.

Thus, if you had asked to withdraw or transfer money from your mutual fund early Monday, when the Dow was down only about 100 points, your investment would still be treated as if it were sold at the market’s close, when the Dow was down 508 points.

Remember that transfers out of your mutual fund can take as long as a week to complete if done during volatile periods such as this week.

Q: What should I do if I have stocks in my individual retirement account?

A: If you are in a self-directed account, you can sell stocks you do not like or switch funds into bonds or other investments. If you have a stock mutual fund, you have the same options as outlined in the previous question.

Q: What are my options if I have a stock mutual fund as part of my 401(k) company savings plan?

A: Most 401(k) plans allow you to change the portion of your account that is invested in stock funds, bond funds or other types of funds.

Most plans, however, allow no more than one switch per quarter, and some allow as little as one a year. And with paper work requirements, it could take as long as a month to complete the switch, so there is no way of knowing where the market will be by the time the switch is completed.

With this limited flexibility, it is not a good idea to switch too often, experts say.

Q: How well protected are my accounts at my brokerage?

A: If your stock or cash is deposited in an account at a major broker and does not exceed $500,000 per brokerage, chances are it is protected.

All brokers and dealers registered with the Securities and Exchange Commission and with national stock exchanges are required to be members of the Securities Investor Protection Corp., a nonprofit agency established by Congress that insures customers’ securities and cash against the failure of member firms.

If a brokerage firm fails, the SIPC will try to merge it into another brokerage or, if that fails, the agency will liquidate the failed firm’s assets and pay off account holders to a maximum of $500,000, with a limit of $100,000 on cash or cash equivalents.

As a general rule, when investing with a broker, make sure the brokerage is a member of SIPC.

Q: What other investments are attractive?

A: Worries about stocks’ volatility already have spurred a flight by investors to relatively safer Treasury securities, certificates of deposit and money-market funds.

So much money has flowed out of stocks and into Treasury securities in the past two days that prices have risen and yields have fallen dramatically. Yields offered on three-month Treasury bills fell Tuesday by an unprecedented 1.94 percentage points to yield 5.03%. Just a week ago, they yielded 6.75%. Thirty-year Treasury bond yields also fell--to 9.43% from 9.71% on Monday and from more than 10% late last week.

Still, Treasuries are a safe investment and are exempt from state tax, an important consideration in California.

Rates on six-month CDs are generally between 6.5% and 7.5%. Money-market funds have been yielding between 6% and 7%, whereas tax-free money-market funds have been yielding between 4% and 5%.

Worries about the stock and bonds markets also could help spur more investment in real estate.

Q: How safe are Treasury securities and tax-free municipal bonds?

A: Treasury issues are among the safest issues around because their interest payments are backed by the U.S. government, which also guarantees payment of principal when they mature. Municipals are backed by the state or local government that issues them and are generally regarded as safe, but not as safe as Treasuries.

However, with either Treasuries or tax-exempts, the governments do not guarantee that the issues will hold their value before they mature. Higher interest rates could depress the prices of Treasury and municipal issues. Thus, conservative investors should avoid longer-term issues because they carry higher risk of capital loss if interest rates rise, advisers say.

Q: Will my pension benefits be in jeopardy?

A: Generally, most pension benefits are safe from the market sell-off. Plans that offer clearly defined benefits to more than 25 employees are guaranteed by the employer’s assets and, if the company were to fail, by the Pension Benefit Guaranty Corp., a federal agency established under the Employee Retirement Income Security Act of 1974. Retired and current employees of the company are covered by the act.

Also, most pension funds hold widely diversified portfolios of bonds, short-term securities and other investments in addition to stocks. So Monday’s 22.61% decline in the Dow cut just a fraction of that percentage from the assets of the overwhelming majority of pension funds.

Staff writer Bruce Keppel contributed to this story.