FOR anyone who found last year’s nine-month rally in global equities perplexing, or frustrating, then 2010 seems to have brought a hint of sanity back to the markets. The sell-off of the past few weeks feels like a vindication for those who have been suspicious of the strength of the equity rally since the beginning of March. Meanwhile, market bulls remain convinced that, after a consolidation, equities will once again carry on as before, ending the year significantly higher than current levels.
To try to make sense of where the markets are heading, it’s worth analysing the drivers of last year’s equity rally. If those drivers still pertain, then maybe it’s reasonable to think that the rally will continue after a reasonable correction.
The bullish case argues that last March stocks were oversold. Prices were so low because investors were looking for a collapse in the global financial system, which didn’t happen. Instead, the economy entered into a cyclical downturn. Weaker, over-indebted companies didn’t survive, allowing leaner more competitive firms to prosper. We are now entering a period of recovery, when corporate profits should grow.
The bears maintain that stocks may well have been oversold, but that the market got too far ahead of itself during 2009’s rally. The bears argue that we can’t expect the kind of recovery that occurs in the normal business cycle. What we experienced was a banking crisis that grew into a full-blown systemic financial crisis.
More seriously, the bears point out that the underlying problems in the global economy haven’t been addressed: government intervention means toxic assets still clog the system and after massive stimulus programmes, these toxic assets are now the liabilities of the taxpayer rather than the shareholder. So now the strain is on sovereign debt rather than financial institutions, as elevated debt levels and plunging tax revenues lead to unsustainable budget deficits and refinancing concerns. For stocks, this means it will not be a return to business as usual and we can forget about a strong recovery in prices this year.
Whichever side is proved to be right, investors must be nimble. For this reason CFDs and spread bets play an important role, as they are flexible trading tools which can be used for hedging and speculation.