End Of Bear Market Rallies

The bank reckons these bad macro factors are currently depressing the S&P 500 index by about 40 percent.

Investors look set to witness the end of the recent bear market rallies this week as fresh six-year lows loom for world stocks on growing economic gloom and doubts over the effectiveness of governments' bailout plans.

Unlike the previous sell-off, when financial system stress intensified after the collapse of Lehman Brothers in September, equity markets are exhibiting weaker correlation -- links between various indexes -- which allows investors to exploit a divergent pace of a downturn in key economies in the world.

After reaching the lowest level since 2003 on November 21 world stocks, measured by MSCI, have enjoyed six mini rallies, rising between 7-17 percent each time.

A bear market rally is loosely defined as a periodic uptrend within a broader bear market that starts when an index falls 20 percent from its cycle peak.

But now the index has slid to within 5 points of the November low.

This comes even though Washington enacted a landmark $787 billion stimulus bill this week and pledged $275 billion this month to help the housing market on top of the $700 billion financial bailout fund.

"We will go below the autumn lows. We are going lower than the lows," said Ian Kernohan, economist at Royal London Asset Management. "On the economic front there were some expectations the rate of deterioration will slow. That feeling has evaporated. Confidence in banking rescue measures will take quite a while to come through and there is a lack of patience."

According to ThomsonReuters data, the fourth-quarter earnings growth rate for the S&P 500 index stands at -42.1 percent, which is the lowest since at least 1998. The rate saw a sharp downgrade from the July estimate of positive growth of 59.3 percent.

Seven of the ten sectors in the index are reporting a yearly decline in earnings, which is the highest number of sectors recording negative growth since the fourth quarter of 2001.

DELEVERAGE WAVE

Investors are also giving up hopes that the wave of deleveraging by hedge funds and the speculative investment community would slow sharply in early 2009.

Data by U.S.-based TrimTabs Investment Research showed hedge funds saw another $74 billion in redemptions in January, the second highest on record after $117 billion left in December.

In the week ended February 18, all equity mutual funds posted an outflow of $10.7 billion, compared with $2.4 billion the week before.

"The sickness is really the leveraging-deleveraging force and despite the easing of many credit spreads, the deleveraging process is continuing," said Marc Chandler, strategist at Brown Brothers Harriman.

Barclays Capital's crisis model shows the probability of a crisis -- which shows the potential for a sharp equity sell-off during the following month -- remains high at 89 percent, having hit 99 percent last month.

The MSCI world equity index fell more than 7 percent last week, its biggest weekly loss since the November 23 week. The index is down more than 15 percent since the start of the year.

FALLING CORRELATION

Asset market correlations tend to spike higher in times of accute financial market stress. Cross-market correlations are still high, with risky assets such as stocks and oil falling in lockstep when risk aversion rises.

However, internal market correlations are weakening in equity markets.

Goldman Sachs estimates that its three-month average pair-wise correlation among 25 of the most important global equity indexes has fallen to 60 percent over the past week, with much of that reduction coming since the start of 2009.

This correlation spiked to above 70 percent by mid-October, compared with an average of about 40 percent over the past 20 years.

"The degree of impairment in financial markets is now comparable to that prevailing in 2001, which was a more 'plain-vanilla' economic downturn," the U.S. bank said in a note to clients.

"This appears to have allowed investors to focus on the macroeconomic features of the downturn, and differentiate between equity indices on that basis."

However, Goldman also estimates that the macro drag on equities is worse now than at any time since the early 1980s, or excluding inflation, worse now than at any time since the Great Depression.

Bad macro factors include near record low manufacturing activity, real borrowing rates around 300 basis points above their post-war average, a significant decline in corporate earnings relative to trend and credit spreads on investment grade corporate bonds near their widest since 1932.

The bank reckons these bad macro factors are currently depressing the S&P 500 index by about 40 percent.

"If credit spreads, the ISM, corporate profits, and real interest rates were all to go back to their mid-2007 values, this would imply an S&P that is about 50 percent higher from current levels," Goldman said.