The bears are back in town

5 February, 2010

The stock market’s New Year hangover entered a new and more dangerous phase this week. It was clear that the spectacular post-crisis bull market could not continue indefinitely and few were surprised when investors collectively paused for breath. But now markets across the globe are sinking fast and there is a danger that negative sentiment will become entrenched.

The powerful bull market that started in early March last year was built on strong foundations. Prices were very low, and good value compared to analyst predictions for earnings. It appeared that officialdom had constructed a successful, if expensive, solution to the banking crisis and there were no more nasty surprises lurking in the financial system. It was not, after all, the end of the world as we knew it. Turbo-charged by ultra-loose monetary policy, by close to zero interest rates and quantitative easing, investors started to seek out opportunities. Greed overcame fear.

We now at a critical point where the balance may shift back to fear. The problem is that the bad news keeps on coming, most obviously in the increasing risk of a Greek debt crisis, but also in worries about Chinese growth, in disappointing corporate figures and stubborn unemployment. This is all happening while governments and central banks around the world are starting to withdraw their artificial life support from the market. After such a strong bull run, equity prices are high and now need a stream of good news to stop them falling.

Although the market quickly shook off the troubles of Dubai, a full blown government debt crisis in a founder member of the eurozone would prove hugely damaging. A Greek default would make it much more expensive for governments around the world to borrow their way out of the recession. The Greek problem is already causing a re-evaluation of the risk attached to all government bonds and Spain and Portugal seem to be the next focus of fear. It becomes logical to ask ‘where next?’ in the way banks were systematically targeted in the wake of the failure of Lehman Brothers.

Unfortunately, there is now evidence of generalised fear, or risk aversion, in the market. The strength of the US dollar can be viewed as a proxy for such fears. The pound was trading at $1.68 at Christmas; it is now trading at $1.58 and the story is similar for other major currencies. Another sign is that stock markets have been harder hit in emerging markets than in safer countries such as the US. Since its recent peak the DOW has fallen by 6.5%; the Hang Seng has fallen by 13.6%.

It is normal for market recoveries to suffer setbacks of 10% but beyond that there is significant risk that it will turn into a bear market. We look set to test that limit. The global economy desperately needs some good news to stop the negative momentum but, right now, it is difficult to see where it will come from.