Bears catch up with bulls as equity markets nosedive

Stockmarket losses this month have raised the spectre of an end to the bull run in equities.

Since the second week of May, regional bourses have slumped by between 5% and 14% (see chart). The MSCI World index was down about 6% at the time of writing.

The falls come in the fourth year of a powerful equity bull run that began in March 2003 and whose strength and duration has surprised many investors.

However, concerns are growing that the good times could end because of rising inflation, hikes in short-term interest rates, higher bond yields and a sinking dollar (see chart below).

The fall in the dollar has sparked fears that the American current account deficit is unsustainable and will be accompanied by slowing economic growth. “It is impossible to know if this month’s market falls are going to develop into something more serious,” says Mark Hall, a UK equity portfolio manager at Rensburg Fund Management. “The average stock in the UK is up something like 100-125% since 2003. At some point people will take money off the table.”

Halls argues that “more falls could create some quite interesting situations” but says it is nonetheless “a lot harder” to find attractively valued investments. He thinks the British stockmarket might trade sideways for some months.

“The shock in the past few days has been abrupt dollar weakness and strong commodity prices,” says Kathryn Langridge, head of international equity products at Invesco Perpetual. “Markets are scared by the whiff of inflation.”

Langridge adds that “powerful liquidity surges” have driven stockmarkets and points out liquidity growth is slowing. She describes a correction as “overdue” but maintains “we do not see this as the start of a bear market at all”.

“In broad terms, risk is not being properly priced into equity markets,” Langridge says. “But we’d still be overweight equities – the macroeconomic environment is still good – although we are mildly bearish about the US and a weakening dollar is not a good backdrop for sterling investors.”

Mike Lenhoff, chief strategist at Brewin Dolphin Securities, argues that investors need to “go back to basics” and examine the economy following this month’s stockmarket weakness.

“The fundamentals still look quite good,” he says. “Earnings have been growing well for longer than expected and market valuations have been satisfactory. Markets may trade sideways for some months, and then move ahead if the earnings picture is still good and the outlook on borrowing costs is clearer.”

Lenhoff believes dollar weakness “is good for the US”. Rather than higher inflation and interest rates, he says, “the more important effect will be a positive one on US corporate profits, which will be good for the US equity market”.

However, Lenhoff warns that the key risk stems from long-term interest rates. “Higher-than-expected inflation could force central banks to push up interest rates,” he says. “That would bother me the most. I’m watching the US Treasury market like a hawk to see what will happen to long-term rates.”

CSFB, an investment bank, maintains that investors should continue to back equities. It says the global economic environment is “still excellent” and claims to see “clear-cut value” in the stockmarket on some valuation measures.

But other analysts are much less cheery. Andrew Smithers of Smithers & Co, a financial consultancy firm, ously overvalued”.

Capital Economics says global imbalances, particularly the American current account deficit, have “come home to roost” and, along with “speculative bubbles”, undermined investor confidence.

In a research note published last week, Capital Economics predicted “a sharp slowdown in the US economy and in the growth of US profits next year, as the housing market cools, undermining equities as well”.

Meanwhile, Charles Dumas, an economist at Lombard Street Research, says the bear market began on May 11, the day when equity markets suffered major falls. “Stockmarkets in the middle of 2006 are confronting a tight Federal Reserve and European Central Bank, sharply higher bond yields and a downswing in potential profits,” he says. “A significant question is whether the tidal wave of bullishness in such a wide range of financial instruments has been heavily based on leverage – implying an impending financial crisis.”

Previous equity market falls in the bull run since 2003 proved to be good buying opportunities. But the spectre of a new bear market and economic slowdown appears to be looming large over the recent sell-off, as analysts wonder whether the levers subsequently used to revive the global economy have stored up trouble.

“The volatility of the past few days is attributable to a build-up of excessive risk-taking by investors,” says Tim Bond, head of global asset allocation at Barclays Capital. “This risk taking has been fostered by excessively low interest rates over the past few years. In short, the volatility illustrates not that rates have gone up too much, but that they have been far too low for far too long.”