In Part 1 of this story, I wrote about how we're currently stuck in the fraud phase of the market. There aren't any formulas to predict how long this phase will last, but we do know something about the process.

For example, we know it's almost impossible to forget the trauma as long as new examples keep coming to light. What this market needs, then, is a period when no company blows up. With several telecommunications providers and equipment makers teetering financially, and with several companies in that sector also under investigation for accounting irregularities, though, the likelihood that we'll get through the next two months without another

WorldCom

seems small.

Second, we know that publicly witnessed punishment of the guilty parties can speed the healing process. Pronouncements by public officials that fraud is a bad thing aren't enough. Investors need to see some of the guilty go to jail in order to feel some faith in the system again. The current process -- long on announced investigations and hearings and short on trials -- is dragging out, not shortening, the fraud phase of this bear market.

Third, it takes credible demonstrations of strong leadership from a CEO to restore the reputation of any company that has been damaged by fraud or suspected fraud. Promoting a respected No. 2 executive from a current management team probably won't do the trick. After WorldCom, where the fraud was discovered after the departure of CEO Bernie Ebbers and implicates the CFO and the comptroller, investors aren't inclined to believe that there are just one or two bad apples at any company.

The Biggest Worry

It's this need for strong leadership to end the fraud phase of the bear market that worries me the most. Charismatic leadership styles -- like that of Ebbers or Dennis Kozlowski at

Tyco International

(TYC)

or Joseph Nacchio at

Qwest Communications

(Q)

-- have been badly tarnished. Charismatic leaders at many companies simply marched whole cadres of executives to the ethical brink and then over it.

But it's hard to turn around a badly damaged company without a charismatic leader. Employees need someone who can lead by example, create enthusiasm where there is none and inspire heroic efforts when the rewards are few. Those kinds of leaders are always in short supply, and now the inventory seems especially low.

And frankly, many boards aren't about to hire another charismatic leader anyway. The trend in post-fraud, fix-it hires so far has been to bring in detail-oriented, operations experts. It remains to be seen if operations-savvy CEOs like the reputedly low-key Richard Notebaert, the new CEO at Qwest, can find enough charisma to pull the job off. If they can't, this will extend the fraud phase of the bear market.

That makes the job of finding the turnaround leaders even tougher: Some qualified CEO candidates simply don't want the jobs. The uncertainties surrounding personal liability for CEOs may be the most pressing reason to turn down the top job these days. The

Securities and Exchange Commission

recently implemented an order that requires the chief executives and chief financial officers of 947 of the nation's largest companies to sign off on the accuracy of the company's books.

That means if the books are cooked, the executives could face civil penalties or even jail time. Given what many CEOs don't know about bookkeeping, I can't say I blame potential occupants of the CEO chair for shying away from that kind of blanket liability.

Yet another problem: Directors and officers insurance, which provides liability coverage for corporate executives and members of the board of directors, has been getting more expensive and harder to find in recent months. Part of that is due to insurance companies shying away from this market when so many scandals are breaking. But another reason is that many companies that write these policies made classic underwriting mistakes over the past few years, offering coverage at prices so low that they lost money. Many of those companies have been pulling out of the market.

All three of these points make me worry that the fraud phase of this bear market is going to drag on for a while yet. The healing doesn't look like it will be quick.

What You Should Do

If that's so, what should investors do about it over the next year of two? First, I think investors need to recognize exactly how long and slow the process of rebuilding any damaged individual company is likely to be. That argues against rushing to buy shares of damaged companies in the hope of a quick turnaround.

Second, I think investors need to realize that the slow overall market recovery during the fraud phase argues against taking risks on companies that might blow up. This means avoiding companies with overcompensated CEOs, compliant boards of directors and compromised public accountants. Stick to companies with track records of conservative accounting, eye-on-the-ball boards, and CEOs who haven't been afraid to dish out bad news from time to time. The returns are likely to be modest, but they're likely to be modest for the market as a whole. And modest returns don't offer much chance to recover from big risks gone bad.

And finally, I think investors who say they are in the stock market for the long term need to adjust their own expectations about the way companies and markets, and indeed capitalism as a whole, work. Capitalism is messy. Projections, even those made on the best information, fall short. Earnings stray from expectations for reasons no more predictable than a customer postponing a big order by a week at the end of the quarter.

If we don't want company managers to manipulate the numbers, we investors have to become more tolerant of the meaningless deviation of a penny or two or three from expectations.If we continue to demand perfection from the stocks we own, CEOs will continue to do their best to provide it. Even if, in some cases, that means making the numbers up.

At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column.