Short rally doesn't alter the trend – that's down

The markets have been like "a mountain stage in the Tour de France" of late, says Citigroup. The rebound from the mid-July lows, underpinned by financial stocks which had gained 30% by late last week in Britain has faltered over the past few days. If the downtrend of the past year is already resuming, this latest upswing will have been an unusually short bear-market rally.

According to a Citigroup analysis of the FTSE All-Share index, there have been 13 temporary upswings within a longer-term downtrend since 1970, lasting an average of a month. The average gain has been 13.6%. The index had gained 6% since 16 July by last Wednesday before easing back. The best performers in a bear rally are the sectors that were weakest before the bounce.

Investors were hoping for a boost on Monday after the US Congress passed a bill shoring up the ailing mortgage giants Fannie Mae and Freddie Mac. The Treasury will be able to extend unlimited loans to the firms or buy equity stakes in the lenders to help them continue providing liquidity to the mortgage market. The bill will also see the authorities guaranteeing $300bn of mortgages for struggling homeowners facing soaring loan costs as their mortgage interest rates are reset upwards.

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However, with just 400,000 homeowners expected to benefit, the result is likely to be "only a modest dent in the rate of foreclosures", says Paul Krugman in The New York Times and now the market's attention is back on the forthcoming losses at banks as the economy and the housing market deteriorate. "It seems irrational in the extreme to anticipate a bottom in financials before the bottom in housing is in," as Stephanie Pomboy of MacroMavens told Barron's.

Two more regional banks have gone under and Merrill Lynch has "added to the Wall Street horror show", says the FT's Lex. It announced an $8.5bn share offering and $5.7bn of writedowns, largely a result of ditching mortgage-based derivatives valued at $31bn pre-credit crisis and only recently written down to $11bn for $6.7bn. The latest Merrill writedowns may put pressure on banks to slash the value of similar holdings, "deepening their financial woes", says Ben White in the FT.

With house prices still falling and foreclosures rising, no one knows how many more writedowns are in the pipeline. Worryingly, trouble is spreading to prime mortgages, with JPMorgan warning that the outlook here is "terrible". Then there's the prospect of defaults on credit card and car loans as consumers retrench, while Lex notes that "commercial and industrial lending has yet to deteriorate markedly in this cycle".

Total losses in this cycle could reach $945bn, according to the IMF, which also highlighted the danger that further losses by cash-strapped banks would squeeze lending. By mid-June, US bank credit was already declining by an annualised 6%, says Peter S. Goodman in the International Herald Tribune, while mortgage rates have been climbing. And global growth is fading. After the inflationary "hump we have slump", says Edward Hadas on Breakingviews. Sliding property markets and high fuel and food prices have sapped spending in America and Europe, while Asian exporters are beginning to feel the pinch.

Earnings forecasts are still unrealistic, with markets yet to trough as we are, at best, half way through the process of profit forecasts coming down, according to Citigroup's European strategists. Indeed, European earnings weakness has only just started to spread beyond financials, says Morgan Stanley. Similarly, to be bullish on US stocks now, says Investorsinsight.com's John Mauldin, you have to believe the recession is over and earnings are going to rise. A 15% drop in stocks from here "would not be out of historical character".