This bear market is “nowhere near over”

The roller-coaster ride continues. Last week the S&P 500 posted its biggest weekly gain in almost five years (4.9%) and the FTSE 100 hit a two-week high. But this wasn't enough to prevent the MSCI global index losing 7.7% in January, its worst start to a year since MSCI began collecting data in the 1970s. And this Tuesday saw hefty slides on more bad news in the US and Europe.

Further news of a potential rescue of ailing bond insurers, whose failure would "represent another lurch downwards in the credit crunch", as The Economist puts it, has buoyed confidence of late. As we noted last week, if they fail or lose their AAA-credit ratings, then those investors who are only allowed to hold top-rated debt will be forced to sell, while the value of billions of dollars of derivative contracts that investment banks have agreed with the insurers would be hit, forcing more writedowns. Time is running out for the insurers. Ratings agency Moody's will complete a review of the extent of subprime losses in the sector by late February, so further downgrades are on the cards.

Meanwhile, US corporate insiders bought more shares than they sold in January for the first time in 13 years. In the past 20 years, stocks have not fallen in the year after this has occurred; indeed, the S&P has gained an average of 21% in the subsequent twelve months, the last seven times buying outstripped selling (between 1988 and 1995). So America's directors are banking on the worst being over. Either they're right or they're making a bigger mistake than in 2000, when they were pretty bullish at the peak of the market before rapidly turning bearish, as Mark Hulbert says on Marketwatch.com.

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It's hard to share their confidence. As Robin Hepworth of Allchurches Investment Management Services told Bloomberg.com, directors may be underestimating the effect of the US economic slowdown on earnings. Recent data has hardly been encouraging, with employment dropping for the first time in over four years in January. On Tuesday an index of the service sector showed that activity contracted for the first time in five years last month; the gauge plunged from 54 in December to 42 in January.

House prices in 20 major cities fell at an annualised rate of 16% between August and November, and with unsold homes at an almost "unprecedented level, prices are likely to fall a lot further", says Capital Economics. That bodes ill for consumption, as mortgage equity withdrawal accounted for at least 2% of annual GDP growth in 2003-2006, says John Mauldin on Investorsinsight. And the credit crunch is worsening, with banks set to tighten lending criteria across the board in the first quarter, according to the Fed's latest survey.

Moreover, optimistic earnings estimates leave plenty of scope for disappointment. US earnings are expected to grow by 17% in 2008, according to Citigroup, even though the country seems to be sinking into recession. Nor does it bode well that margins are around 40% higher than their average since 1980. Globally, analysts are pencilling in 13% earning growth this year, yet worldwide profits have typically slid by over 30% when the US has a recession, says Richard Beales on Breakingviews. And Citigroup says that since 1970 the average decline in global stocks during US recessions has been 36%. We're less than half-way there.

In Europe, earnings are expected to expand by 10% in 2008 as sales growth increases, says Goldman Sachs. But with the US set for recession and global growth slowing, a more likely scenario is an 8% slide in earnings. Goldman has also noted that European and UK shares slump by 33% in a US recession, implying more pain ahead. "Investors are grossly underestimating the global impacts of the deflating credit bubble," says Richard Bernstein of Merrill Lynch. This bear, adds Alan Abelson in Barron's, is "nowhere near over".