So where do we go from here? When will the grinding losses in the stock market end? When will the body count in executive offices stop climbing? When will U.S. businesses return to something like business as usual?

I've tried to answer those questions in the past, and, like most observers, I haven't exactly covered myself with glory. It seems that most of us (and I include professional analysts and individual investors alike) trying to make sense of the capital markets have been at least one step behind since the technology-dominated

Nasdaq

market started its meltdown in March 2000.

Initially, it was going to be just a correction -- remember that prediction? Then a normal bear market. After that, the projections were for a severe bear market that would be over in two years. And most recently, for a bear market that would drag on until investors got over the crisis of losing confidence, created by a string of ethics scandals.

And now? If the current decline continues much longer, I think the attempts to understand this market will move into the realm of superlatives. If the

S&P 500

finishes down for a third straight year in 2002, for example, this will be the longest bear market for that index since the four consecutive down years from 1929-1932, easily surpassing the duration of the terrible bear market of 1973 through 1974, and matching the three-year bear of 1939-1941. And given the magnitude of losses recorded by the Nasdaq Composite -- 39% in 2000, 21% in 2001, and 30% so far in 2002 as of the close on July 2 -- I'd expect to start seeing reports asking, "Is this the worst bear market of all time?"

The Two-Stage Bear Market

Fine with me if you want to pursue that historical debate, but it does have one unfortunate side effect. If you start focusing on this as the "worst" stock market of all time, then you wind up emphasizing the unprecedented nature of this bear market. (Actually, it's not the worst market of all time -- just the worst market since we started collecting reliable performance numbers sometime this century.)

Once you decide that this market has sailed off into uncharted territory, you can't really say much about where you're headed -- except that it's "uncharted." And the "uncharted" is generally a pretty scary place to most people. That's why all the old maps fill the blank spaces not with smiley faces but with pictures of sea monsters.

I think we're much better off -- and our projections are likely to be more useful -- if we keep this financial market on the map by breaking it into two pieces. First, there's the bubble phase that popped in 2000. Second, there's the financial fraud phase that really didn't start cooking until 2001 and has only shown its full rancid potential this year.

Now I know these two phases are unalterably connected. The incredible paper and real wealth created during the bubble provided the temptation that led so many company executives to decide in favor of their bank accounts instead of their ethics, for example. And the desire to keep the bubble inflated led to much of the accounting fraud that is now coming out. That fraud, in turn, made it possible for stock prices to rise higher than they would if they were simply powered by investor greed. That resulting stock surge, in turn, made prices fall even faster and harder when the bubble ultimately broke.

But I still think it's useful to separate these two phases, because treating them individually tells investors something important about how long the current downturn is likely to stay in control of the stock market and, to a degree, in control of the U.S. economy.

No More Bubble

For example, from a two-phase perspective, the pure bubble phase (when in retrospect stock prices clearly were out of line with all tested methods for valuation) ended sometime this year. The stock market is now undervalued if you employ any of the historical methods for figuring valuation that take into account interest rates. Not by a great deal -- somewhere around 10% to 15% -- and mostly thanks to record low interest rates. But undervalued nonetheless.

If valuation were the market's only problem, we would have seen the bottom by now. Granted, the bull market we knew and loved in the 1990s may not have returned; rather, the bottom most likely would have been followed by a time when prices went nowhere.

But at some point this year, we passed out of the valuation phase and into the fraud phase. The key here is that the prevalence of accounting fraud makes valuation calculations essentially meaningless to many investors. If investors can't trust the numbers, if they fear that any reported growth could turn out to be manufactured by dishonest executives, the calculations that show stocks to be undervalued can't be trusted either.

I might think that

General Electric

(GE) - Get Report

, for example, is cheap at its recent price, since it's trading at a multiple of just 17.3 times projected 2002 earnings per share. But if I can't trust those projections, then I won't buy General Electric until I'm convinced that either (1) the stock price is so low that I can't get hurt even if the numbers are cooked, or (2) once again I can trust analysts and executives who create the projections.

Investors now know that a stock like

WorldCom

(WCOME)

can sink from an unbelievably low 83 cents a share to an even more unbelievably low 6 cents a share in one day. It's frightening to think how low valuations would have to go in order to make investors feel protected.

So we're stuck with alternative No. 2, requiring the return of trust. Meantime, the stock market is mired in the fraud phase.

Coming tomorrow in Part II, Jubak looks at how to speed the healing process and what investors can do in the meantime.

At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column.