FOLLOWING a three-month rally in global equities, stock market indices have eased off as investors face the prospect of a slow and protracted recovery and question whether a correction – of some magnitude, at least – is now overdue. <br /><br />Given the sharp rise in equity prices since March, many investors are now wondering what is next for the stock markets. <br /><br />In the case of Britain’s FTSE 100, which had been consistently trading in the 4,300-4,500 range for nearly six weeks, the sideways trend was always going to be broken – it was just a question of which way and when.<br /><br />Further clarity on this matter appeared over the last fortnight when the UK’s blue-chip index was regularly trading below the 4,300 support level, despite a string of generally more positive economic news.<br /><br /><strong>OVERLY OPTIMISTIC</strong><br />But is this correction purely a retracement from overly optimistic highs or is it the sign of a second move lower that some bears have been forecasting all along?<br /><br />Alastair McCaig, senior derivatives trader at contracts for difference (CFD)-provider WorldSpreads, says that a lot of people have been trying to call the bottom, and the longer we trade sideways the greater the chance that we have indeed seen it. <br /><br />But over the next few months the index may struggle to move sharply higher. Ronnie Chopra, senior derivatives trader at Falcon Securities, says: “The markets will probably stay within the 4,200-4,500 range in the foreseeable future as summer gets into full swing and volumes lighten.” It is estimated that CFD traders will only do half their normal trade sizes at this time of the year.<br /><br /><strong>INFLECTION POINT</strong><br />And Goldman Sachs’ strategists note that at the inflection point in the market – where we could be now – investors tend to lengthen their investment horizons and start to look at “mid-cycle” multiples, paying for a part of this expected future value in advance. This means that as the risk premium starts to decline, usually as the worst part of the economic cycle is passed, the price/earnings (p/e) ratio starts to expand.<br /><br />“We fully expect this phase to be followed by one where the multiple starts to fall as earnings catch up. This often results in the market treading water or moving in a narrow trading range for some time, a prospect we think fairly likely perhaps through much of 2010,” they say.<br /><br />But while we may not see a significant move higher in global equities, Ian Scott, analyst at Japanese investment bank Nomura, also believes that the current global equity correction will be short-lived. This is for three reasons.<br /><br /><strong>RISK APPETITE</strong><br />Firstly, the drop in risk appetite evident in the equity market is not apparent in other assets – such as well-behaved credit markets – while implied volatility (the estimated volatility of a security’s price) and the yen exchange rate suggest that benign risk conditions prevail. <br /><br />Secondly, cyclical indicators such as the Baltic Freight Index and commodity prices continue to rise and analysts have recently been upgrading slightly more estimates than they have been cutting.<br /><br />And thirdly, there is evidence that the aggressive policy actions taken by governments have had a positive impact on investor behaviour. <br /><br />What’s more, in terms of stock valuations, Morgan Stanley analyst Ronan Carr says that valuations for European stocks are attractive and at the bottom of the historical range on many measures.<br /><br />The MSCI Europe index – which includes the UK – is trading at almost all-time lows on trailing price/earnings ratio – the current share price divided by earnigns per share over the previous 12 months – and price/dividend measures.<br /><br />“On one of our preferred measures, which takes an average of price by volume, personal consumption expenditure and price/dividend, Europe is 35 per cent cheaper than the US,” Carr says. <br /><br />“Taking sector and cycle effects into account, Europe is still clearly cheap compared to history, although perhaps less extremely so,” he says. Perhaps rather than popular emerging market indices and the safe haven of the US, the contrarian should be looking closer to home.