Why it's still not safe to go back in the water

If you think the tide has turned, think again. With affordable credit in short supply and the change in the lending climate likely to last for years, the markets won't be bouncing back any time soon.

Once Bear Stearns had been rescued, they thought it was safe to go back in the water, citing the bank's collapse as typical of the sort of event that signals a market bottom. However, to call that March 2008 level a long-term bottom is akin to saying the tide has stopped going out long before it has finished turning. In the same way that waves come in even when the tide is going out, so stock markets ebb and flow within the major trend.

The direction of the developed world's stock markets is unerringly down. Why would that not be the case at a time of credit contraction when banks will not lend so readily, if at all, to those they lent to before? The change in lending criteria that has taken place will last for years. There were many propositions that banks previously supported which now they wouldn't touch with a barge pole. It is totally impossible for banks to revert back to those previous, deeply flawed, lending practices. Readily available, affordable credit lubricates the economic engine, no economy can get up to speed if credit is in a state of contraction which it is.

Last Thursday, 5 June, the front page headline in the Daily Telegraph was "Economy uniquely at risk' of major downturn". The headline was based on recent research by the Organisation for Economic Co-operation and Development who warned of a further 10% fall in house prices we should be so lucky if it's only 10%. They also said 200,000 jobs are to go. The OECD support the Bank of England's decision to deal with inflation by at least holding interest rates unchanged. The Bank of England's altered monetary policy is negative for the economy: high interest rates impact on consumers' disposable incomes, especially when oil and food prices are at record levels.

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The evidence to our eye is convincing: the next leg down for the UK stock market is underway and will next lead to the FTSE 100 testing its January 2008 low of 5339. In the final analysis, it will all get very interesting when the FTSE's 2003 low of 3278 is eventually tested - an appointment with investment harsh reality that we expect to take place.

If you look at the yearly chart for FTSE, you can get an idea of this third leg down. The first leg led to the important low in August 2007 of 5822. Then, and in spite of the evidence, that a dreadfully serious credit crisis had started, FTSE rallied back to its August 2007 high at 6752. From there it again headed down, at first in an orderly fashion, before falling off a cliff. From the first low in August 2007, it took five months for the second leg to breach the August low before bottoming out at 5339. From January there was a bear market rally that has now failed. In our view, the January low of 5339 will be breached later this month, five months from the January 2008 low.

When January's low is breached, we will expect to see panic selling. The low for this third leg should be later this month, below 5000.

We eagerly await a decoupling of Asian markets from the developed world's markets. A number of them for example Japan, Taiwan and China, are very close to delivering technical buy signals. If those signals are triggered as Western stock markets are in decline, it will be very impressive. If not, we will simply delay our initial entry.

Important indicators give considerable support to this view. The 15-year gilt yield, at the point of writing, is 4.8%; 3-month money is 5.79%; and UK base rate is 5%. Further tightening by the Bank of England is likely to cause that yield curve to steepen further as long-dated gilt yields fall and short-term interest rates rise.

That 15-year gilt yields are lower than 3-month interest rates is a harbinger of future economic woes and likely recession, a point we have laboured for a long time.

We publish, for the third consecutive time, the Advance Decline Index for the UK stock market which offers no relief whatsoever to our bear market forecast.

Below is the chart for the All-Share index gross dividend yield. When stock markets fall, yields rise because the dividend income becomes a greater percentage of the reduced value. Historically, the UK dividend yield has moved between 3% and 6%. Now that we have a decisive bull market for the dividend yield, it is reasonable to assume that it will rise to at least 6% - we think higher. Although it is not exactly proportional, you can assume that, if the yield doubles to 7.5%, the UK stock market will fall by nearly 50% from here!

David Schwartz in the Financial Times last Saturday, made an interesting observation. There have been twenty one occasions since the end of the first World War when the UK stock market fell by at least 3.5% in the first five months of the year, a bear market was running in twenty of those twenty one years. The one exception, 1994, saw shares finish the year little changed from the end of May level. By the end of May this year, the FTSE All-Share index was 6% lower than its starting point for the year. So the odds of this being a primary bear market year are very high indeed.

By John Robson & Andrew Selsby at Full Circle Asset Management, as published in the threesixty Newsletter