Why the idea of new bear market is not so farfetched

When the Bank of England slashed interest rates to their lowest level in 53 years on Thursday, the members of its monetary policy committee were probably not expecting the market to fall almost 6 per cent. The fact that it did says much about the mindset of investors right now.

Instead of focusing on the positives of the MPC’s dramatic move, the market decided it smacked of panic and showed just how sick the UK economy had become. Some traders said it demonstrated that the MPC was powerless to stop the UK sliding into a deep recession.

Such views need to be put in context. It is easy to forget, given recent stock market volatility, but the FTSE 100 actually entered a bull market this week – a bull market in this case being defined as a 20 per cent gain from a recent low.

In the six trading sessions leading up to and including Tuesday, the FTSE 100 climbed 20 per cent from the five-and-a-half-year low of 3,852 reached on October 27. That advance was the UK’s biggest “bear market” rally since the terrorist atrocities of September 2001, according to Citigroup, and came after the trailing price/earnings ratio for the FTSE All Share index dropped to 8.3 – the lowest level since 1974.

Of course, the key question is what happens next. Will the lows of October 27 be retested and do new ones lie in wait. Or will the rally resume? Could this even be the start of a new bull market?

Teun Draaisma, Morgan Stanley’s highly rated equity strategist, is in no doubt. He believes the recovery will continue and prudent investors should not be “short of equities”. “We believe at eight times trailing earnings, or 14 times our estimate of 2009 trough earnings, the bad news is in the price.”

Company directors seemingly agree. October saw record levels of purchases by executives as they looked to take advantage of the recent falls. Citigroup notes that the two previous highs for director share buying came towards the end of the Russia/LTCM crisis in 1998 and the last bear market in 2003.

Other are less sure. Albert Edwards of Société Générale says moves to slash interest rates and flood the system with liquidity are to be expected. But will they solve the problem? And the problem is a big one – a debt super-cycle of grotesque proportions that has lasted for a decade caused by loose money bail-outs.

“It has been a house of cards waiting to fall,” Mr Edwards says. “The market has to slide much further down the slope of hope into Dante’s inferno.” He believes that markets are currently in the eighth of Dante’s nine circles of hell.

However, there is a third outcome – that markets remain range-bound. This argument runs as follows. Equity markets are caught in no-man’s-land between supportive central bank policy moves and attractive valuations on the one hand, and deteriorating economic and corporate data on the other. So, while it is too late to sell, it is too early to buy.

Clearly, the world’s central banks will remain steadfast in their support of the financial system, but equally there will be no let up in the grim economic and corporate data over the next year to 18 months, particularly in the UK. Indeed, on Thursday, the International Monetary Fund said the UK would suffer a downturn next year on a par with the recession of the early 1990s, with the economy shrinking by 1.3 per cent.

With equities caught between a rock and hard place, it is difficult to see the market making much progress. Of course this might be no bad thing. A period of calm could be just what is needed to repair frayed nerves and restore some confidence. A steadier market could, for example, see the return of mergers and acquisition activity as the strong pick off the weak. It might also tempt institutional investors to put money into the market.

Indeed, this is broadly what happened in the last bear market in 2003. After hitting 3,200 in March of that year, the FTSE 100 rallied sharply, reaching 4,500 by Christmas and then moving sideways for the next nine months before kicking on. Could history repeat itself?

neil.hume@ft.com