Hamish McRae: It's shaping up to be a year of two halves: first the pain, then the gain

Economic Life: If there is a sell-off in the next few weeks, it will be a consolidation of the bull market, not the end of it
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The Independent Online

Complacency is back. Not the top-of-the-market eternal optimism of two years ago, of course, but a general sense that, for all the obvious difficulties, the world recovery is secure and that there will be many economic opportunities over the next few years. Accordingly the markets have been cantering along steadily, dismissing bad news and cheering up when better information comes along. All the major markets are at or close to their one-year "highs", having made pretty much straight-line progress since the first half of last March.

But history has taught us that when people become complacent, things are liable to go wrong. As far as the world business community is concerned there may well be the prospect of a continuing recovery, though maybe a bumpy one. For markets, however, it may be that just a little too much of that recovery is already priced in, and accordingly is vulnerable to some sort of downwards break should a batch of bad news come through.

Quite what that bad news might be is far from clear – but then it never is. There are certainly plenty of candidates, ranging from a further fall in house prices in the US, through poor export figures from Germany to a rise in inflation globally. All we can say is that even in gradually improving times, there are inevitable reverses and we are due for one soon. You don't need to believe that there will be a double-dip to the recession to note that there are frequently pauses in the recovery. If one were to occur, markets would be vulnerable.

One person who has done a lot of work on market cycles is Chris Watling at Longview Economics, and a recent warning signal from him deserves a wider airing. He draws attention to a number of bearish indicators. The first is a "sell-off" indicator that his company has developed, which measures short-term variations in the market mood. It has just tripped above the point that indicates that a sell-off of between 5 per cent and 15 per cent is liable to occur in the next few weeks.

This is not conclusive, of course, but of the last six such signals since 2006, five have resulted in sell-offs. Watling has taken the S&P 500 as the base market, as you can see, but the principle should apply to other major developed country markets since in the short term they move pretty much in tandem.

A second warning sign is that investment advisers have become over-optimistic. It is one of the sad commentaries on human nature that when the professional advisers think something strongly they are usually wrong. Advisers were particularly bearish late last year and while the markets did indeed fall further, they were again very bearish last March. So if you listened to them then you would have missed a once-in-a-generation share recovery.

Longview cites a number of other indicators, which I have not shown here, including the very low market volatility at the moment, the US bearish indicator (also very low) and its own medium-term risk appetite gauge (very high). Ignore the details because the message is a common one: the prevailing market mood is one in which people are prepared to take risks and accordingly are ignoring warning signals from the real economy. So the market is setting itself up to be disappointed.

None of this means the bull market is over. Nor does it mean that the recovery will necessarily stall. Far from it. What it means is that there is a good chance of a shift of mood and that this shift might last for a couple of months, maybe longer. I can see lots of reasons why there will be upsets. However if, come the summer and autumn, it starts to become clear that the recovery is picking up speed, then there will be the basis for the next phase of the bull market.

This market perspective chimes with a common-sense assessment of what seems to be happening in the major developed economies. There has been a bounce. There is no question about that. The timing of the upturn varied a bit between different countries, and according to the official figures the UK has been slower to recover than most.

As I have written several times I think those figures are still wrong (they have been revised upwards but not by enough) and that growth began in the third quarter, not the fourth. We will see. But in a way the precise timing of what has happened in the different countries does not matter, for the similarities are more striking than the differences. To generalise about the mass of data that has been emerging, there is a softness, a twitchiness, at the moment as the various public schemes to boost demand are coming to an end and fiscal consolidation looms into sight. It would be surprising if we are not seeing the first increases in interest rates before the summer is out.

My instinct is that this will be a year of two halves: the first half will tend to disappoint but the second will bring positive surprises – increases in interest rates then will be in response to stronger demand. That somewhat optimistic perspective will prove true for the developed world as a whole, not just the UK. It has nothing at all to do with the British political cycle, though it may have some influence on it.

There are two main reasons for expecting the second half to be stronger than the first. One is that there is still a lot of bad news to filter through – bad news from the world's banks, bad news as consumers everywhere remain cautious, bad news from governments as they confront their deficits, and so on. We can see most of this in outline but we can't see the detail. So that holds things until the bad news is in the open.

But the second and more positive thought is that there is huge spare capacity in the world at every level. Once it becomes clear that the bad news is out in the open – and I cannot see this taking more than a few months – that spare capacity can be mopped up. The world economy has the capacity to increase output very swiftly once the demand is there. The big issue here is timing. Things may take longer. It is possible that we will have to wait until 2011 before growth really picks up and the pause of the first half of this year actually runs through into the autumn. I don't think there is much point in trying to be precise about any of this.

But to return to the mood of the financial markets, even if real recovery is delayed until 2011, the markets will catch a feeling for it several months in advance. So if the argument set out here is right and there is a sell-off in the next weeks, it will be a consolidation of the bull market, not the end of it.

As the picture shows, the bull is being savaged by a bear. But it will survive the encounter.