November has arrived and investors are still locked in the paralyzing fear that caused the markets to crash in early October. Bank failures, hedge fund liquidations and overseas turmoil have added to the trepidation that is keeping most investors on the sidelines. Since hitting a low on October 10, the market has rallied slightly, but not enough to convince investors to set aside their fears and return to stocks. That could be a crucial, emotional mistake.

The steep sell off at the beginning of October stemmed from the credit crisis that has paralyzed the financial system since July 2007. By September 2008, as is well documented, several large institutions were forced into insolvency and losses began to multiply throughout the system - especially banks and brokers with huge amounts of credit derivatives and default swaps. AIG was bailed out because the government feared its collapse would ruin the global financial system.

The government’s fears were transferred to the financial system on September 15 and 16 as news of the AIG bailout became public. The speed and enormity of the bailout caused many institutions to reevaluate their own financial position. At the same time Lehman Brothers announced that it was no longer solvent. LIBOR rates jumped, demonstrating that banks were hoarding cash to brace for losses, and reluctant to lend to one another for fear of each other’s hidden losses.

Washington Mutual failed just over a week later, and the government began to consider a $700 billion financial rescue. As institutional fear increased LIBOR rates continued to skyrocket, and then the commercial paper market for financial companies nearly collapsed. Without that necessary lifeline banks began to call in loans and stopped issuing new ones. The types of loans most affected were shorter-term call loans and leverage agreements to hedge funds and private investment groups.

Without the ability to renew credit lines and issue new paper, highly leveraged investment funds (which was nearly all hedge funds) were forced to liquidate assets to meet the avalanche of redemption requests. On September 29 the selling intensified, and finally broke into all-out panic on October 6. The selling didn’t stop until October 10, hitting institutions and small investors alike.

And it wasn’t just the US stock market. Overseas markets were hit worse. Gold, oil and commodity prices plummeted. The gold price decline was most telling; in times of turmoil gold prices almost always rise. The fact the opposite happened is the best indicator that the asset declines were about deleveraging institutions rather than fundamental valuation adjustments.

Since early October the markets have struggled to find a direction. Huge rallies over two and three trading days are wiped out by massive sell offs the very next. The fear that still persists can be clearly seen in the yields of short-term US Treasuries. One-month to three-month T-bills have been yielding almost zero since mid-October (aside from a temporary reprieve coinciding with the first stock rallies off the bottom). That means investors are willing to forgo ANY return just to keep their money safe.

But where this story turns positive is in the longer end of the yield curve. Treasury yields for bonds maturing two years and more from now have been increasing since the panic began - the opposite movement from their shorter-term cousins. That suggests that the flight to safety is short-term as well. Investors are not pulling out of the stock market for the longer-term, otherwise they would be buying longer-term bonds. Instead they are only seeking short-term safety while the markets find stability.

With a lot of cash sitting short-term in safe alternatives, institutional investors have been the only market movers. The hedge fund redemption fear has convinced many market participants, especially “pundits” desperate for attention, that there is another large decline ahead. But in order for that to happen there has to be a surge in redemption requests and a lack of financing options.

The redemption request question will become paramount around November 15, the next redemption gate. While it is likely to be heavy, how many more are there after the September 30 avalanche? And investment funds now have more financing options. The selling in early October showed that many institutions were selling at any price, preparing for a worst-case scenario. Since then, the credit markets have eased. LIBOR rates have returned to normal and the commercial paper market has seen a significant rebound. Margin calls should not be nearly as heavy as in September, and many funds have raised excess cash in anticipation of the redemption.

One last factor is the Lehman phenomena.  The bankruptcy forced the company to put a value on all its derivatives and hard-to-value assets. An act that contributed to the fear that caused the market crashes. Now that it has happened, banks and brokers have a much better handle on the scale of likely losses. Having that knowledge has reduced institutional fear and is likely a big reason the credit markets are beginning to stabilize. A more stable credit market greatly reduces the likelihood of another institutional panic.

For all the reasons above the market action of the past seven weeks points to a deleveraging within asset markets rather than a fundamental revaluation. Now that it has abated the markets can return to worrying about earnings and the economy. Even with some downright awful economic numbers (GDP, employment, retail sales) the market has not declined to new lows. Third quarter earnings reports were less than inspiring, and most included ugly guidance for the fourth quarter, and for 2009. Yet the market still holds. Having been through the worst financial crisis in seventy-five years investors are expecting the worst, and have priced it into their expectations. Anything less than the worst-case will be a positive boost to investor sentiment.

Investors waiting on the sideline could be making a huge mistake. Even if the market goes lower purchasing stocks now will not cost anything other than opportunity. What do long-term investors care about the market over the next few weeks when facing the probability of outsized returns over the next few years of a market recovery? But if the market heads higher, particularly with that huge amount of cash in short-term bonds and money funds, the rally off the bottom might be considerable. Missing that will cost more than opportunity, it will cost real, hard dollars.