Jeremy Warner: Markets take another beating. 1929 again?

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The Independent Online

Outlook: I've wrongly thought we'd seen the point of capitulation on at least two or three occasions in the current crash, so I'm going to give up all pretence of knowing where all this will end. One quiteworrying characteristic of the lurch into the abyss for share prices is that so far it has occurred on little more than average volumes.

Experience of previous, really serious crashes is that the point of most extreme panic is marked by mass selling. So far we've seen quite a bit of forced hedge-fund selling to meet redemptions and to deal with the effect of deleveraging by the banks. It doesn't require much in the way of a fall in share prices to wipe out the capital of hedge funds that have geared themselves up to buy equities. Yet selling by mutual funds has so far been relatively modest. The retail investor has yet to bailout en masse. That may be to come.

Share price valuations are ultimately determined by the outlook for corporate profits, and this can scarcely be said to look good right now. Bank earnings, a large part of the profits of most stock markets, have already been dramatically impaired, and with bad debt experience now rising fast in the real economy, are unlikely to recover any time soon. Other sectors too, from housebuilding, retail, leisure to property and media, are facing dramatic falls in profitability.

As the market topped out a year and a half ago, earnings multiples looked reasonable by comparison with previous cyclical peaks, but it is remarkable how an undemanding rating can be transformed into a fanciful one by a collapse in profits. In every boom, profits in any case become exaggerated. In an effort to meet the ever more demanding expectations of investors and analysts, managements find ways of artificially inflating profits. This element of profitability is the first to go in a bust.

But it is "deleverage" – that word again, I'm afraid – which is the real point of uncertainty for investors. Until there is more clarity on the consequences of credit shrinkage and the asset sales that go with it, few are prepared to take on risk of any sort, and that includes equities.

But there is another, in some respects even more worrying, consequence of deleverage for stock markets. As we now know, much of the growth of the past 15 years, certainly in the US and Britain and to a lesser extent elsewhere too, has come from credit expansion, or leverage. Once this driver of economic growth is removed, and indeed put into reverse, it may also undermine much of the growth that has taken place in corporate earnings. In a world where there is less demand, it simply becomes a lot more difficult to make bumper profits from ordinary business activity. In such circumstances, the cult of equity, which has dominated mainstream investment thinking since the 1950s, loses its appeal.

For nearly five decades now, with only brief interludes, equities have yielded less than government bonds to reflect their perceived potential for growth and the supposed income protection they offer against inflation. That relationship has recently reversed again. Is this just another abberation, as occurred in the post-dotcom meltdown, or is it something more permanent? Many companies will struggle to pay a dividend at all over the next few years, so the reversal is to some extent an illusion based on historic data. Yet the point is still the same – investors are going to demand a lot more in income return for the risk of holding equities.

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