ECONOMETER

…before you return to the stockmarket.

Equity markets have undergone their biggest 5-week rally since the great depression but there are several questions that should be considered to determine whether the gains will last.

1) Why is the rally in equities broad based? On the face of it a broad based rally should come as good news but it also appears indiscriminate with investors rushing to buy any stocks regardless of the underlying factors. This suggests investors are jumping in without looking where they will land.

2) Why are financial stocks rebounding so strongly? Surely all the problems have not been resolved so quickly. Even if the removal of toxic assets are starting to gain traction markets are unlikely to have anticipated the likely problems coming from a new wave of credit card defaults, and comsumer and corporate loan delinquencies as economic conditions deteriorate and unemployment rises.

3) Have markets factored in the outcome of the results of the stress tests on US banks? These results will be known in about three weeks. Although no bank can fail the tests from a technical perspective, there is every chance that some will be found to be in bad shape and in need of more capital.

4) What effect will the impact of accounting changes have? The relaxation of industry accounting standards in the US mean that it will be difficult to gauge losses on a variety of debt. This could add to the uncertainty surrounding valuations rather than help to end it.

5) How will tensions between banks and the administration impact stocks? There appears to be growing tensions between the US administration and banks over repayment of bailout money and the speed at which banks are removing toxic assets from balance sheets. Many banks in the US are reluctant to announce further writedowns despite pressure to do so.

6) How long will positive data surprises continue? Clearly expectations for economic data had become overly bearish over recent months. Data releases have actually come in better than forecast recently as reality has not been as bad as expectations. This in turn, has helped give more fuel to the market rally. Once expectations become more realistic markets will find little support from positive data surprises.

7) Are markets full pricing in the depth and breadth of the recession? It appears that markets are looking at the current economic downturn as if it was the same as past cyclical downturns. This is unlikely to prove correct as economic conditions will not improve anywhere near as quickly as experienced in recent recessions. Moreover, the jobs market is likely to continue to worsen for many months to come. At best, economic recovery is unlikely until early 2010 and even this may be optimistic whilst any recovery is likely to be slow and mild relative to past recoveries.

8)How compelling are valuations? Although the price side of the P/E ratio has dropped sharply the earnings outlook continues to be negative. Analysts have forecast Q1 earnings to drop by around 37% but as the economy worsens and unemployment rises the earnings outlook could like quite bad for some time to come.

9) Are stocks rallying too quickly? Historically equity markets do not rally so rapidly following such a shock on the downside. Any rally is usually slower.

10) Are stocks rallying too early? Stocks rally around 5-6 months ahead of an upturn in economic conditions but as noted above any recovery in the economy is unlikely before early next year, which suggests the stock rally is premature.