Why you should sell this May and go away

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What happened to the bear market?

After six months of upheaval while the money and debt markets have lurched from bad to worse, stock market investors seem to have rediscovered their optimism.

Since the Federal Reserve's bailout of Bear Stearns in mid-March, the FTSE 100 share index has bounced 16% to 6304, and now stands just 6% below the post dot-com bubble peak of 6,732 reached 11 months ago.

So does the stock market know something the rest of us don’t, or is the rally about to end in tears?

Credit where it’s due

When the credit crunch first hit last summer, stock markets stalled around the world and took a nose dive. And rightly so.

Credit oils the economy’s wheels. If bank lending dries up, so does economic activity. Company profits drop and share prices generally decline. That's simplifying things of course, but anyone who has studied the 1929 stock market crash, still by far the most dramatic economic event in the past century, will find the subsequent depression is frequently blamed on a freeze up in bank lending.

Moving forward to 2008, it seems highly unlikely that we've seen the last of the fall-out from the credit crunch. The hits already taken by the banks could represent no more than the tip of the iceberg.

The credit crunch might have began with the entirely predictable failure of the inhabitants of America's trailer parks to keep up with their mortgage repayments. But - despite what Gordon Brown and the rest of the Government would have you believe - US subprime wasn’t an isolated piece of lax lending. It wasn't the cause of the credit crunch. It was just a symptom.

The real cause of the credit crunch was the fact that the world’s banks pretty much abandoned ‘conservative’ criteria, deciding that it was much more profitable to hand out loans to all and sundry almost regardless of the ability to repay. As Chuck Prince, the ex-Citigroup head honcho (who later departed clutching a £42m package when his employer was forced to take mega write-downs) infamously said about the new-style bank lending policies, "as long as the music is playing, you’ve got to get up and dance… and we’re dancing".

Corporate defaults are soaring

So lenders overreached themselves in plenty of other areas too, including corporate debt. And it's starting to show. So far this year, there have already been more defaults than in the whole of 2007, and the outlook for the rest of the year is grim. Ratings agency Standard & Poors reckons the US speculative-grade default rate will rise sharply over the next 12 months to 4.7%, compared with 2007’s 25-year low of 0.97%. And that could be just the beginning.

"There are more speculative grade issuers than at any point in history," according to S&P global fixed-income head Diane Vazza, so defaults could be much higher than in previous cycles, especially if the upcoming recession is worse than expected.

Throw in potential defaults in commercial property, consumer loans, credit cards, even student debt and it becomes clear that there could still be cans full of worms yet be opened, all ready to catch the eye of bank audit departments. And as subprime has already shown us, it’s amazing who’s been busy dabbling in things you wouldn’t have expected. In the ‘good’ times, British banks in particular were keen to buy a slice of the American pie.

The banking sector has already racked up losses of more than $300bn. If it rings up anything like the $945bn level the IMF warned of just a month ago, lenders will be in no fit state to return to anything approaching the good old days of doling out money to all comers. This month we’ve already seen surveys from both the Fed and the European Central Bank indicating that tougher credit criteria are being imposed by lenders and that loan demand, particularly in Europe, is crumbling.

Commodity price power

All this is seriously bad news for future company profits. So why aren't stocks falling - particularly in the UK, which probably has the most exposure to the financial sector of any developed economy?

Simple. It's all down to inflation. Let me explain.

The FTSE 100 index is no more representative of the UK's real economy than the average Premiership football team is a reflection of the talent in its local area. These days the index is stuffed with resource stocks, while many of the big industrial names have dropped out, along with the engineers, retailers and housebuilders. And it’s the miners, who benefit from commodity price inflation, who have been powering the market upwards.

I’ve had a look at the FTSE 100 ‘points’ breakdown over the last 11 months since the mid-June 2007 high. If you exclude all the resource stocks from the index, it would have fallen by almost twice as much from last year’s peak, and would be now standing below 6,000.

So what happens to the Footsie next isn’t so much about the UK economy, as about commodity prices, which keep hitting new heights as investors increasingly embrace the idea that China and emerging markets can keep expanding even if the US falls into recession.

However, as we've been warning in MoneyWeek for some months now, the idea that the US consumer can drop out of the global economy without impacting on demand for commodities seems far-fetched. While we are still fans of the idea of the 'supercycle' - a long-term shift in demand that will see commodities continue to rise for several years - 2008 looks ripe for a correction as the global economy slows.

It's never easy to exactly predict turning points in markets. But it is May - and this year it certainly does feel like a good time to sell and go away.

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