Is the bear market about to make a comeback?

February may have been another great month for global stock markets, but there are strong signs that we could be about to see a return to the bear market that began in 2000.

The long-term transition from "Primary Bear Market" to "Primary Bull Market" is invariably based upon valuation. A low valuation is usually represented by a P/E ratio in single figures. This has traditionally signaled the end of a Primary Bear Market and that has not yet occurred. For this reason we believe the stock market is specifically at risk to a resumption of the Bear Market that started in 2000. A continuation of the Bear Market could be very dramatic and is likely to be triggered by a reversal of the global liquidity story.

Stock markets have another good month

At the time of writing, February is proving to be another positive month for world stock markets. According to Richard Russell, the highly regarded US octogenarian financial market observer, February will be the eighth consecutive month that the Dow Jones Industrial Average has been higher, equaling its long-term record. It has also been observed that there have been 928 trading days without the Dow being one day down by as much as 2%, the longest such period ever.

The FTSE 100 remains strong, justifying our recent decision to reduce bear fund holdings by two-thirds. The residual holding is being watched carefully and ought to benefit from what is now a very long overdue correction.

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Change on the way for markets

Recent data suggests change may be on the way. The British Bankers Association (BBA) said that credit card lending in the UK declined by £496 million in January. This followed a decline in December of £329 million; the January figure is the biggest contraction since figures were first published by the BBA in 1993. This reduction has come about as a result of tighter credit controls by the banks and an increased awareness by consumers in the wake of a series of interest rate increases.

In the US, 22 % of the 400 plus S&P 500 companies, who have reported results for the fourth quarter 2006, failed to meet Wall Street expectations, the highest level of misses since the third quarter 2004. Ashwani Kaul, senior research analyst at Reuters Estimates, said "We are entering a low earnings growth environment". If he is right, the US stock market will struggle at these valuations, which depend very much upon the expectation that earnings growth continues robustly.

Ben Bernanke continues to calm nerves by regularly reassuring investors to expect a soft landing and low inflation. However, Merrill Lynch recently commented on the risks that exist to the "Goldilocks" economic view. Global liquidity could be reined-in; both the ECB and BoJ could raise rates; the Peoples Bank of China likely to restrain liquidity; the deteriorating American housing market; corporate earnings might disappoint.

Stock market indicators: the Volatility Index

The Volatility Index remains becalmed; nothing, it seems, can disturb the complacency. The absence of fear is truly incredible.

The recent decision by the Bank of Japan to increase interest rates by 0.25% has, so far, in no way frightened this horse nor should it, given that the 0.5% remains very accommodative. However, Toshihiko Fukui, Governor of The BoJ, is understood to have taken on the recent G7 view that the yen is out of sync with Japan's relatively robust economic performance. JP Morgan's Chief Economist in Tokyo, Masaaki Kanno, who is also a former BoJ staffer, was prompted to say: "This is an indirect warning from the BoJ, do not expect a weak yen forever."

Stock market indicators: US housing market

The general view is that the worst is over for the US housing market, although that optimism must have been somewhat dented when it was reported that home starts for January were down 14% to 1.4 million, a ten-year low. Furthermore, the Commerce Department reported that there are 2.1 million housing units standing vacant, the highest number ever.

The sub-prime mortgage market has, for two years, been key to burgeoning property prices; it is now in a state of distress as a result of very high delinquency levels. The share prices of some of these lenders have been savaged. Recently, in one day, the New Century Financial Group, the second largest sub-prime provider, saw its share price fall 36%. More recently shares in Novastar Financial, the nineteenth largest US mortgage lender, fell 42.5% in one day.

Stock market indicators: Dow Theory

To our surprise, Dow Theory has signaled positively for the US stock market; the question now is, will this horse lead the other three or will it stumble and fall back, we watch and wait.

As flagged in our previous issue this has caused us to take action as far as the Japanese stock market is concerned - more on that later.

Stock market indicators: yield curves

Although inflation fears have caused a modest rise in long-term interest rates, yield curves remain inverted.

Long-term interest rates are still meaningfully lower than short-term interest rates and whilst that continues, pressure on future short-term interest rates is likely to be down. It has long been the case that an inverted yield curve is a signal for a future recession. Without a change in the situation, a recession must be expected with corresponding weakness in stock markets.

Japanese stock market: increasing our exposure

It was recently reported that Japan's economic growth in the fourth quarter 2006, on an annualised basis, was 4.8%, 1% above the consensus. Consumer spending for the same period was up 1.1%, again above consensus.

For some months we have been monitoring Japan's second section, an index of smaller Japanese companies centred on the domestic economy rather than the giant international blue chips of the Nikkei. Last year it suffered a significant set back. Since July 2006, it has been basing out and, in our view, has now delivered an attractive buy signal. We are initiating positions in most portfolios amounting to about 5% of portfolio values. We expect these investments to benefit from the developing Japanese economy and from the inevitable return to strength of the yen.

The advantage of purchasing investments at these levels, following a long period of consolidation, is that it allows us to set a very close stop-loss. You will see this from the published chart. If, as we expect, these investments prove to be successful, we will, in due course, look for an opportunity to increase exposure by a further five percentage points.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

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