My guide to how to worry: Know what to worry about and when if you don’t want to get spooked out of a rally–or get killed in a correction

(Originally posted on October 14 but several readers have asked me to repost.)

What me worry?

On a day when the Dow Jones Industrial Average closes above 10,000 for the first time in a year and when the Standard & Poor’s 500 stock index closes within kissing distance of 1100 at 1092 ?

Of course.

When the market is rallying and everyone is getting kind of giddy, it’s exactly when you should be worrying. You don’t want to head for the exits just because an index has crossed some arbitrary number. That’s silly. But you would like to know what the chances are that something will go wrong.

How bad it might be if something did go wrong.

And when. Don’t forget the “when.” Deciding to sell because you’re worried that something bad is set to happen in 12 months is a guaranteed way to leave a big chunk of change on the table.

So what are my worries and what timetable are they running on?

The Fed decided to go slow on removing housing stimulus–and that’s a good thing

I heard what I was hoping to hear in yesterday’s statement from the Federal Reserve’ s Open Market Committee: the U.S. central bank isn’t going to cut back its support for the U.S. mortgage market ahead of schedule or abruptly.

And that will keep mortgage interest rates from jumping so much that they kill off any chance of a recovery in the housing sector.

The Federal Reserve has been buying mortgage-backed securities hand over fist during the financial crisis. It has had to since private buyers have pretty much disappeared from the market.

 And without someone buying this paper banks would have quickly run out of mortgage money to lend. (Banks make mortgages and then Wall Street lumps those mortgages into mortgage-backed securities. When those are sold to another buyer, the bank that made the original mortgage gets its money back and can make more mortgages. It’s a way to multiply capital and that keeps mortgage money available and relatively cheap.)

The Fed launched a program to buy mortgage-backed securities late last year. Right now the Fed is about 2/3 of the way to the $1.25 trillion target that it set for the effort. The fear was that the bank would stop soon buying soon by redefining that target as “up to” $1.25 trillion rather than buying the full amount.

We have nothing to fear but a replay of 1937 itself

The specter of 1937 hangs over the economy and the stock market.

That’s the year that over confidence that the Roosevelt administration had whipped the Great Depression and that it was time to balance the federal budget led to another deep recession that wiped out three years of growth and sent the economy reeling back to the Depression depths of 1934.

The Dow Jones Industrial Average, which had climbed 127% from a low of 85.51 on July 26, 1934 to a high of 194 on March 10, 1937,  would fall by 49% from that peak by March 31, 1938. And since it only takes a 50% loss to wipe out a 100% gain, in March 1938 the Dow was at 98.95 just about the 85.51 that it had been in July 1934.

Thanks to another collapse in 1942 stocks wouldn’t match that 1937 peak until 1945.

A few days ago I wrote a post “Most of the time rallies like this have been followed by a gain over the next 12 months”  (http://jubakpicks.com/2009/09/14/most-of-the-time-rallies-like-this-have-been-followed-by-a-gain-over-the-next-12-months/) arguing that the odds were on an investor’s side since a year after almost all big rallies–like the one going on now—the stock market was still higher in a year.

Almost. The one big exception, the one that delivered a loss big enough to wipe out portfolios, came in 1937.

It’s that “almost” that constantly gives me pause as I look, not so much at the stock market, but at the economy and at what passes for our national discussion of economic policy these days.

The comforting thing about looking back at that economic and investment disaster in 1937 is that we did it to ourselves. Bad policy decisions, not accident or fate, led us over the cliff in that year. So all we have to do to avoid a repeat of the results is to avoid the policy mistakes right?

Disturbingly, there are plenty of signs that we might well be prepared to do it to ourselves all over again.