Investors may take comfort if they believe it's darkest before the dawn, because right now it's pitch black.

The banking and credit crisis have led to the forced deleveraging of institutional investors around the globe who are no longer capable of borrowing to sustain their positions. This has unleashed protracted, record-setting volatility across virtually every asset class as overleveraged investors, led by hedge funds, unwind from stocks, bonds, property, commodities and currencies.

In past bear markets, huge price swings would hit like an ocean wave that eventually subsides after it strikes. But the energy in today's tempest seems to be feeding on itself like fissionable material and continues to rock asset prices daily.

It's been a year like none that anyone managing money has ever seen. "It is now consensus," says Jan Loeys, head of global market strategy at JPMorgan, "that we are in a severe world financial and economic crisis, the worst since World War II." And unlike past sell-offs where there was cover in certain sectors and foreign bourses, investments across the board have gotten slammed as years of gains have been wiped out.

Once sure-footed funds like large-cap growth Fidelity Magellan and Legg Mason's Value Trust have tanked 45.59% and 52.02%, respectively, the price of the former reeling to 2005 levels, the price of the latter to those of 2003.

The only equity fund category in the black this year is bear funds shorting the market. According to a recent Morningstar survey prepared for Financial Advisor, these funds are collectively up more than 40% for the year through October 30.

An Unmitigated Bloodbath
Morningstar reported that U.S. diversified equity funds have lost more than 36%. Growth funds were off 38.59%, while value funds did little better, sliding 34.16%.

Diversified foreign equity funds collapsed as well, by more than 45%, as global investors sought sanctuary in the dollar, curbing the tailwind such funds' investors had at their backs when the U.S. currency was declining. The rallying dollar exaggerated losses in eurozone securities by 9%, and in Australian investments by nearly 17%. This meant the United States was the second-best-performing market in the developed world in dollar terms, down 33% for the year through October, according to MSCI's country indices. Only Switzerland performed better, off by 29.05%.

The hope that certain foreign markets would be uncorrelated and investors protected by decoupling has died a sudden death. Europe isn't generating the economic thrust necessary to drive the global economy in the absence of U.S. growth. And emerging markets are staggering as developed markets fall into recession.

Morningstar found that European stock funds have lost nearly half their value in dollar terms since the beginning of the year. Emerging market funds were down by more than 54%.

Another investment strategy turned on its head is the search for safety in commodities. Morningstar's natural resource fund category was off more than 43%, and funds focused on precious materials have lost more than half their value. Investors in long-short funds haven't fared as badly as others, but they've still found themselves in the red, off 13.43%.

Even the investment-grade bond "safe haven" has proved to be otherwise. Total returns on long-term U.S. bond funds were off nearly 14%. Global bond funds did a bit better, losing 7.46%. Every category of municipal bond funds has lost money. And emerging market bond funds lost nearly a quarter of their value.

The only long position in Morningstar's entire fund universe that increased in 2008 was short-term government bonds, which were up 1.79%.

Broad View
When the subprime crisis initially hit the markets in the summer of 2007, many thought that we would be through the worst after a year. But clearly that timeline has changed. In October, the International Monetary Fund said "the world economy is entering a major downturn in the face of the most dangerous financial shock in mature financial markets since the 1930s." It believes that over the near term, "financial conditions are likely to remain very difficult, restraining global growth prospects."

Coordinated central bank intervention across the globe may have staved off the immediate breakdown of the banking system. However, Nouriel Roubini, a professor of economics at New York University's Stern School of Business who saw the crisis coming two years ago, worries especially about the collapse of the shadow banking system-broker-dealers, nonbank mortgage lenders, hedge funds, money market funds and private equity firms that borrow short, are highly leveraged and invest long. He thinks the failure to refinance "short-term liabilities may lead to widespread bankruptcies of solvent but illiquid financial and nonfinancial firms."

But not all assessments are bleak. Ron Sloan, fund manager of the $1.3 billion Aim Mid-Cap Core Equity Fund (GTAGX) believes that while volatility will remain, the markets have largely adjusted to the credit crisis and the ongoing recession. "We certainly don't have a crystal ball," says Sloan, "But our company-specific research does give us insight into what we believe are reasonable valuations under conservative assumptions."

Chen Zhao, managing editor of BCA Research, an independent advisory firm, thinks markets have been oversold. The worst may not be over, but he is optimistic. After the October blowout, he finds that "all the signs are pointing to a medium-term rally. But it is still unclear how sustainable this rally will be."

Strategies
Few managers are jumping wholesale back into the markets. But many are making specific moves.

Ron Weiner, CEO of RDM Financial, a Westport, Conn.-based independent advisor with $650 million of assets under management, recommends investors lock in tax losses and simultaneously swap into higher yielding securities of comparable quality to maintain market exposure. "This is a cautious way of generating real savings by sheltering profits you've already taken from capital gains taxes as well as up to $3,000 in ordinary income," explains Weiner.

Just as important, he believes in stockpiling losses, which can be carried forward without limit to offset future gains. He expects sheltering benefits to be even greater in the coming years given the likelihood that capital gains taxes will rise.

A fund play he likes for yield is the $2.9 billion Thornburg Investment Income Builder (TIBAX), a global equity fund with a touch of bond exposure. Focused on large-cap value companies with strong earnings and solid franchises, the fund has lost more than one-third so far this year. But this has pushed its yield to 7%.

Leo Marzen, partner at the New York City-based Bridgewater Advisors with $700 million under management, is looking to swap out of some of his actively managed equity funds and into indices. For example, he has sold out of his 5% position in Chesapeake Core Growth Fund (CHCGX), which has seen five years of gains wiped out by its 2008 year-to-date loss of 42%. He's shifting into the DFA US Core Equity Fund (DFEOX), which has outperformed Chesapeake this year by 10%, has an expense ratio that's 111 basis points cheaper and has a yield that's 172 basis points higher.

"Not only is the swap allowing us to lock in a tax loss and avoid taxable distributions," explains Marzen, "but we are using the opportunity to reposition these assets away from a large-cap growth bias to a fund that has a tilt toward smaller-cap value shares."

Marzen is also attracted to closed-end funds that invest in master limited partnerships, specifically energy pipeline businesses that generate consistent cash flows. He likes Kayne Anderson MLP (KYN), a closed-end fund that's currently yielding 10.53%.  

Lord Abbett fixed-income strategist Zane Brown sees clear dysfunction and opportunity in the high-grade bond market, where fear has trumped fundamentals. He points to the irrationally small and negative yields on short-term Treasurys. During major periods of disruption, he would anticipate high-grade corporate spreads to move from around 80 to 130 basis points above Treasurys, not into the 400-plus basis point area that we've been seeing.

Brown is recommending high-grade, ten-year maturities because of their extensive offerings and liquidity and because they capture most of the yield curve with less volatility than longer maturities. His biggest concern is that "both institutional and retail investors ignore the major government initiatives and convince themselves that a Great Depression-like market is inevitable."

Across the Atlantic, Morgan Stanley's European strategist Teun Draaisma believes that "despite the bad fundamental outlook, prudent investors should not be short equities and long-term investors should start averaging in." The reason is that four key market indicators-valuation, capitulation, risk and fundamentals-are all flashing "buy." When this has happened in the past, markets typically rallied over the next six months.

Despite the sheer scale of the sell-off-with equity valuations sliced by one-third, cheap-looking commodity prices and high-grade corporate bond yields that look like a once-in-a-generation opportunity-advisors must remember that this crisis is unlike any we've ever known. The behavior of previous bear markets may not mean anything if the underpinning of our economy continues to erode. "It's better in this kind of environment to be sure the knife has hit the floor rather than trying to catch it on the way down," Weiner says.