The Pain Isn't Over Yet

At

major turning points, stock markets move in precisely the opposite direction to the one the herd expects based on the prevailing fundamentals. Bull markets begin in the depth of recessions, when investors have given up on the belief in any recovery and when doom and gloom prevail. Conversely, when the sky is cloudlessly blue and phrases like New Economy, New Paradigm and Goldilocks Scenario are in vogue, the odds of a serious bear market arriving increase significantly. Nobody rings a bell at the onset of a downturn—rather, bear markets sneak in, like a thief in the night, while the investment community is sleeping, confident that its rich market gains will grow ever richer.

To understand the recent sell-off in global equities and whether it will turn into a bear market, you first need to analyze the remarkably heady period that preceded it. Fearing deflation after the meltdown of tech and Internet stocks in 2000 and the terrorist attacks of Sept. 11, 2001, the U.S. Federal Reserve Board cut the Fed fund rate from 6.5% to 1%. The easy availability of low-cost loans triggered a dramatic rise in borrowing, which lifted the prices of all assets, including stocks, real estate, commodities, bonds, art and wine. As U.S. consumption boomed, the nation's trade and current-account deficits exploded. But when economic growth is dependent on accelerating debt growth, the supply of money and credit has to continue accelerating in order to keep the good times rolling. This is no longer happening—not just because the Fed has tightened credit but because the market has done so. In late 2006 some cracks in the credit system were already becoming visible when several sub-prime lenders went out of business as home prices began to decline. Lending standards quickly tightened and as credit flows into housing slowed, the sector experienced some illiquidity. Consumption growth waned and the rate of growth of the U.S. current-account deficit, which is the principal driver of international liquidity, decelerated. The impact wasn't felt right away, not least because Japanese and foreign investors continued to borrow in Yen and invest in higher-yielding, riskier assets around the world. As a result, several emerging and developed stock markets became perilously overvalued. As I warned in TIME's Jan. 29 issue, this debt-fueled euphoria created "the greatest asset bubble ever."

As always happens when bubbles occur, naive neophytes, overconfident speculators and overleveraged money managers all leaned together on one side of the investment boat. When the boat became totally imbalanced it was enough for only a small wave—initially, the mere rumor of regulatory changes designed to cool China's stock fever—to sink the ship. On Feb. 27, China's main stock index fell 8.8%. Because of the huge leverage and increased computer trading that characterize modern finance, this sell-off triggered sharp declines in other markets from Russia to Malaysia, Japan to the U.S.

So, where do we go from here? Is the recent turmoil just a short-term correction in a rising trend, as the Goldilocks crowd maintains, or are we faced with the beginning of a bear market? I believe it's the latter. For a start, monetary conditions and international liquidity have tightened as a result of slower credit growth and a housing slump in the U.S.—and no matter how much money the Fed injects into the system, housing is unlikely to recover swiftly because ultimately prices depend not only on money creation but also on demand and supply. Equally ominous, equity valuations remain decidedly unattractive in most markets, especially in places like Latin America, Russia, India and China, which had risen almost relentlessly in recent months. Most equity markets shot up with so little volatility that speculators were encouraged to borrow and bet with ever greater abandon. Now, with confidence shaken by the belated realization that risk is not dead after all, they will be less inclined to ignore the reality that the global economy and corporate profit growth are likely to be far more disappointing than their giddy optimism led them to believe.

So what should investors do? Instead of buying the dips and moving into riskier assets, they should sell into the rebound that will now unfold. In particular, they should reduce risk by unloading stocks in more extravagantly valued markets like China and India. And they should shift money into the safety of short-term U.S. treasury securities or into less economically sensitive stocks in areas like pharmaceuticals and food; these will benefit from economic weakness either on an absolute or relative basis, as short-term interest rates decline. The only risk to this strategy is that markets might recover swiftly and reach temporary new highs. However, it will merely be a climb to a higher diving board from which the plunge will be even deeper.