Fresh signals: Bear Market of 2007-2008 will soon end

The UK stock market fell sharply in recent months. At its recent intra-day low, prices were down by 47 per cent since peaking in June 2007. I suspect a healthy rebound will soon begin.

Historical Perspective

To see why a rally might be just around the corner, a brief review how the downturn unfolded might be helpful

A bursting of the US real estate bubble started the ball rolling. Investors then took fright over deficiencies in the sub-prime lending market. It soon became apparent that banks were up to their ears in sub-prime assets that were literally, in some cases, not worth the paper they were printed on.

The net widen within a few months. Financial derivative of all kinds and shapes eventually became implicated in the dodgy asset-linked sell-off.

Eventually, the survival of many major financial institutions came into question and investors began to panic. The panic became self-feeding. Fears about the stability of some institutions caused other institutions to refuse to lend to them.

This led to further funding problems – a self-fulfilling prophesy.

Where We Now Stand

This brings us to the heart of the problem. The broad stock market sold off because bank funding is the grease that lubricates the economy. Wounded banks tend to reduce lending. This can drive the economy into recession.

In other words, it wasn't the banking sector by itself that wounded the stock market. It was the fear that their foolish behaviour would drive the broad economy into recession.

Happily, the banking crisis now shows signs of bottoming out. Authorities around the globe are addressing the crisis with a zeal that was unimaginable just a few months ago. Although every action was not 100 per cent effective, they have repeatedly signalled a willingness to provide further aid packages if current actions are insufficient to steady the ship

Media Contribution

Just as the banking industry showed signs of stabilising, UK investors began to worry about prospects for a serious economic downturn. "Worry" is the wrong word. Try fear – raw unadulterated fear. The economy and the stock market have become the lead story on the 10PM news each night.

Looking Ahead

To my way of thinking, the bad news is now in the price. This includes a full set of objective facts as well as all of the raw fears and emotions that cause investors to sell shares. For this reason, I think the stage is now set for a solid rally. Here are some of the issues that lead me to this conclusion.

First and foremost, investors often forget that the stock market discounts the future. Shares often move well ahead of the broad economy. It is quite common for the two to move in different directions. Widely held beliefs that fresh bull markets can not begin if the economy is behaving poorly are factually incorrect.

Also recall that the UK stock market declined by as much as 47 per cent since peaking last year. This is much larger than the typical UK bear market which typically declines by around one-third.

Some investors think this time is different. The barrage of banking collapses, housing declines and a deteriorating economy makes this downturn more dangerous than most.

They may be right. But it is also worth remembering that "This time is different" is a chronic bear market refrain. Think back to headlines during the bear market of 1990 that was triggered by high interest rates, double-digit inflation and negative equity. Remember 1998 when the LTCM hedge fund collapsed and Fed chairman Alan Greenspan stated he had never seen such tight credit conditions.

Of course, economic problems might worsen if western governments do not address the problem. We could even return to the horror of the 1930s. But, happily, governments are responding and will keep responding. They have no other option.

Another factor to consider is that scary news headlines, like the ones we have seen in recent times, have a silver lining. They frighten weak holders out of their positions and set the stage for the next advance. Such headlines often appear at the tail-end of a bear market.

To my eye, there is a striking disparity between proactive steps taken by many governments and the flood of daily news reports that breathlessly suggest the end of the world approaches. These stories are unsettling, even if little has been added to the previous day's story. In contrast, the favourable implication of positive news is often downplayed by the mass media. They also address issues that have already been discounted by the stock market.

I suspect that a calm and more even-handed analysis of recent events would reassure investors rather than scare the devil out of them. A good example was recently provided by Financial Times columnist Martin Wolf, a highly regarded economist.

He studied the UK's financial rescue package from three angles: will it rescue the banks, be too costly and will it prevent a serious economic downturn.

Wolf's analysis is instructive. He believes the scheme will rescue our banks and will not be too costly. He also believes a depression will be avoided. A steep and prolonged recession is possible but can be minimised by continued government action.

If he is right, and I agree with his conclusions, investor fears that a serious economic collapse lies ahead will eventually moderate. Current prices reflect strong negative expectations.

As perceptions change, I suspect shares will recover some of the recent lost ground.

One final positive note is that economic stabilisers are automatically kicking in just like basic economic textbooks predict. Oil prices recently declined by half. Other commodity prices are also sharply falling. Interest rates are down. The current environment is far from perfect but momentum moves in the right direction.