One of my investment heroes, Sir John Templeton, has long maintained that true investors delight in falling securities prices because they love a bargain. Back in January of 2000, Nasdaq was making its dramatic run to 5,000; a year later, the chastened index lay quivering at half that level. After such a big decline, even naturally conservative, retired investors find themselves asking, "Are stocks on sale yet? Is it time to increase my allocation, or is a better opportunity coming?"

Bargain Shopping

Some years ago, I visited the famous basement at Filene's original Boston store, looking for a burgundy leather briefcase. None of my previous retail experiences had prepared me for what I was about to encounter. Filene's unusual pricing system may have been a classic example of free-market efficiency, but it certainly does not bring out the best in human beings.

I could tell the other creatures in the basement that morning were human by their general appearance, but certainly not by their behavior or by any of the sounds emanating from them. They did walk upright, at least when they were not on all fours rummaging through the lower cupboards. They were highly uncommunicative, jealously guarding all goods within reach of their extremities. They uttered a variety of nonverbal sounds, ranging from what I imagined were expressions of profound grief to squeals of delight.

I glanced about the large, low-ceilinged room. Bare fluorescent fixtures dangled between the steam pipes. Everything had been painted cream, probably during the Hoover administration. Most of what might generously be referred to as merchandise seemed to fit more or less into the category of apparel. Dresses, suits and such were crammed onto pipe racks without signs; other items were heaped on large table-height surfaces separated by narrow aisles. Perched on these piles were flimsy cardboard signs indicating what one might find there: underwear, sport shirts, slacks and other such items.

Because I was intent on acquiring a particular item, I was quickly discouraged by the general disarray of the establishment, the paucity of user-friendly signs and especially by the intimidating patrons who crowded the aisles, some of them in stages of undress, apparently related to their efforts to try on some of Filene's offerings.

Swallowing hard, I decided to look upon my present circumstances as a challenge, instead of panicking, which was my visceral instinct. I had survived many years in the competitive canyons of Wall Street; there was absolutely no reason to be afraid in the basement of a Boston department store. I spotted a 50-something female who seemed more relaxed than the other aisle-dwellers. As I approached her, I was heartened to see that she was wearing a store name tag.

Upon asking whether I might find a leather briefcase here, the attendant (or keeper or whatever her role was) directed me to an area under a staircase, where I saw a great assemblage of nonapparel items gathered beneath an intriguing sign that said simply "Misc." In an unexpected burst of helpfulness, the woman asked if I was familiar with the store's pricing system. Surprised that there might be a system of any kind underlying this madness, I admitted that I was not.

"Well," my tutor intoned ever so seriously, "every item has a price tag on it. That is the price you will pay if you buy it today." ("How terribly ingenious!" I thought to myself.) But then she went on, "If the item is not sold today, tomorrow the price will be 10% lower. This goes on every day until the item is sold. If you see something you like, you may either buy it or leave it there and wait for the price to go down ... taking the chance, of course, that someone else will buy it first."

Aha! Now I understood the allure of Filene's Basement! It was a war of nerves, sort of like a continuous bear market, I thought. You are reluctant to buy something you want, even if the price is attractive, because if you wait, you might buy it for even less tomorrow. But tomorrow, you will face the same dilemma, and tomorrow again, until it is no longer available. Then you will have to buy at a normal price in the upstairs store.

I didn't find a burgundy leather briefcase in Filene's Basement that morning, but the experience was one of those life lessons that you do not forget. From it I have distilled a general philosophy for making decisions about "bargains" that has helped me in my role as a professional portfolio manager. To wit:

Most of the time, quality investments are not "on sale." Market activity is usually conducted in the "upstairs store," with fairly orderly pricing, by buyers and sellers whose behavior you more or less understand. In this environment, I stick to my asset-allocation plan and only shop for specific investments I need to maintain the intended balance in my portfolios.

There are rare occasions when the market loses its balance. This is when quality investments wind up in the bargain basement, mixed willy-nilly with the questionable stuff, and the price of everything is collapsing daily. This sort of chaotic environment presents an opportunity to load up on quality merchandise at truly bargain prices. In this setting, I am willing to raise my allocation for the asset class that is "on sale."

In the wake of last year's technology rout, some have begun to wonder whether, in fact, the current market presents one of those rare opportunities. After all, many great companies' stocks have been marked down rather dramatically from the prices at which they were freely changing hands a year ago. Shares of Cisco fell from $82 to $33, GE from $60 to $42, Intel from $75 to $30, IBM from $134 to $80, Wal-Mart from $69 to $42, Microsoft from $118 to $41, Worldcom from $55 to $14.

Do these prices represent true bargains, or have they just been reduced from unrealistic to something approaching normal? Have we seen the worst of this bear market, or is there more devastation ahead? Your clients and mine want to know, and they are looking to us for guidance. My current advice to our firm's clients is that there are at least three reasons to hold onto their wallets for the time being:

The stock market indexes do not represent great values.

Fundamentals will probably get worse before they get better.

Gloom has clearly not yet replaced investor optimism.

In short, the markets are still fairly orderly. We are still conducting business in the upstairs store. There are none of the signs of chaos that attend inflection points in the markets when great bargains can be had. And, most important of all, the prices are not that great!

Investor Emotions Are Key

I am not teaching you anything new when I say that the prices of shares are a function of corporate earnings multiplied by investor enthusiasm. Price = Earnings x Enthusiasm. The price/earnings ratio, or P/E, is how we monitor the level of enthusiasm. The faster earnings grow, the more enthusiastic investors become about future earnings. Conversely, when earnings head south, optimism tends to recede; the longer the earnings cycle stays discouraging, the more gloom tends to displace optimism. The result on prices is a double whammy ... a lower P/E ratio applied to lower earnings.

With the benefit of hindsight, we now know that when Nasdaq was bid up to 200 times earnings last March, investor optimism was out of control. True believers imagined that the business cycle had been repealed. Although Nasdaq has since been cut in half, at 100 times earnings it is hard to infer that investors have become cautious. Their sense of well-being is intact. There is no feeling of urgency. This doesn't look at all like Filene's Basement. We are definitely still in the upstairs store.

The incredibly optimistic market valuations circa 1998-2000 represent the culmination of 18 years of confidence-building stock-price gains. While investors were enjoying the last nine years without a business-cycle interruption, their mantra became "buy the dips." And every time they bought during a dip in the market, they made money! People are slow to give up what has worked. It is only during the past nine months of intermittent pain that some have begun to change their tune to "sell the rallies." If business fundamentals continue to deteriorate, you will hear a lot more of this song.

When the Federal Reserve cut interest rates last month, before its scheduled meeting, these graybeards were telegraphing their concern that the economy was unraveling faster than expected. Consumers, saddled with record debt, are pulling in their horns. Is this a surprise? Let me see, I check my 401(k) on the Internet and realize I'm down 20% in the last four weeks! I open my monthly gas and electric bill to see it's gone up $120. Then I go to the mall to shop for a big-screen TV? I don't think so!

But corporate spending on technology will keep growing, right? Sorry to disappoint the New Era buffs, but it's starting to look like same ol', same ol'. A capital spending binge leads to overcapacity, leads to price cutting, leads to lower earnings. When earnings fall, captains of industry slash capital spending and hand out pink slips.

We cannot know how long it may take for the old bullish thought pattern to be replaced with a new, bearish mindset. But it does seem probable that a bull market of the unprecedented length and magnitude of the recent one will not quickly be erased from the investor psyche. A return to "normal," if that is what lies ahead, could be a long, drawn-out process with hopeful rallies, sell-offs and gut-wrenching, emotional flip-flops.

The downside risk from this level is still quite frightening, especially if you are responsible for retirement portfolios. Business profits are still near their cyclical high as a percentage of national income, with lots of room to come down. Worse yet, the P/E measure of investor emotions is still in the stratosphere. If falling earnings should turn optimism to fear, panic will be right around the corner!

A consistent characteristic of major market moves is that investor emotions, when reinforced by financial developments, tend to run to extremes in both directions. And these extremes eventually correct.

I have designed a simple "word graph" to describe this pattern from bottom to top and back again:

The right side of this chart is steeper than the left to indicate that a market's declining phase is usually faster than its ascent. Although Nasdaq has tumbled 50% from its peak, my appraisal is that we are just entering the "fear" level on this emotional chart. Whether we will cycle directly into the panic stage I have no idea. But until we do, I do not see an opportunity to raise our equity allocations for the sake of scooping up bargains. Until mutual fund investors scramble for the exits, I don't believe we will have finished the emotional cycle.

Equity mutual funds have yet to experience a sustained outflow. Cash reserves among all equity funds were just 5.5% recently. This does not afford much protection against a surge in redemptions; apparently fund managers themselves are still more worried about being out of the market when the next run-up begins. If they have to start meeting redemptions and, at the same time try to increase cash reserves, Katy, bar the door!

They say a bear market has three legs, and the third is usually the worst. We have certainly seen two, at least for Nasdaq. If and when we get the third, I believe we will have a genuine bargain-hunting environment. That is when we'll want to raise our equity allocation and back up the truck. I'm looking forward to it!

J. Michael Martin, J.D., CFP, is president of Financial Advantage in Columbia, Md.