Worrying about a selloff, but perhaps not yet

 

Financial markets keep giving investors a scare usually beginning with a tumble in Chinese shares which then ripples across other assets elsewhere.

It is all about whether the sharp stock market rally of 2009 is about to break and a hefty correction is in the offing.

Anything can happen, of course, but some of the conditions that have propelled stocks, commodities and other risk assets higher since March notably huge government stimuli are still in place.

As long as they remain, its seems likely investors will be spared a significant sell-off.

The latest scare, triggered by poor U.S. consumer confidence data, saw a Wall Street selloff spill into Monday, when Shanghai stocks dived nearly 6 percent, world stocks as measured by MSCI fell close to 3 percent and the VIX volatility index had its biggest daily gain since April.

The higher the volatility index, the lower investors' appetite for risky assets such as equities.

Tuesday's rebound world stocks rising, China up 1.4 percent suggests the party is not over yet. But the reason for concern is understandable.

Shares have recovered so much, so quickly since March that a correction is seen by many investors as almost inevitable. 

It took the MSCI world stock index around 10 months to fall 100 points from its November 2007 high, but only five months to gain that amount on the way back up from this year's low.

It stands 53 percent higher than it did on March 9.

Other recovery-sensitive assets have seen similar growth.

Oil and benchmark industrial metal copper have made massive gains this year of 51 percent and 100 percent, respectively.

Investors in those markets have fed on a tide of risk-seeking in global equity markets, in part driven by China's restocking hence the focus on Shanghai's bourse.

Mohamed El-Erian, the chief executive of top bond fund Pacific Investment Management Co, said on Tuesday the rally in U.S. stock markets had topped out.

"Valuations are running far ahead of where fundamentals are" El-Erian told Reuters Television.

RECOVERING FROM GLOOM

There are signs that the market is coming off the boil although this is not the same as having a major correction. 

World stocks, for example, are on track for only their second monthly loss albeit a small one since March, while Shanghai's bourse has lost 14.7 percent this month.

It is also true that a lot of this year's equity gains have come as a result of investors ditching the overly pessimistic stances they adopted last year when they feared a Great Depression-style meltdown and banking system collapse.

Such pessimism can be measured to an extent by the latest U.S. earnings season. Thomson Reuters data shows a whopping 72 percent of S&P 500 companies did better than analysts expected.

If that pessimism has now been lifted, the "catch up" element in this year's rally will have gone, theoretically allowing markets to get back to normal or indeed fall back.

But the market rally has also been driven by signs of a quicker than expected recovery in the global economy.

Few, for example, would have expected Germany, France and Japan to be at least technically out of recession in the second quarter. Or that U.S. job losses would show signs of levelling off in July. China's growth accelerated, too.

Investors are now waiting to see something more concrete is to come, such as actual job creation.

"Absent a sustained economic recovery, it will be difficult for equity markets to continue to move higher" wrote Bob Doll, BlackRock's chief global investment officer for equities.

DELAYING THE INEVITABLE? 

Economists put a lot of the recovery down to the huge stimulus packages that governments from Washington to Beijing pumped into their economies to stop financial collapse.

These have not yet run their course and there is a case to be made that economic improvement and bullish market sentiment for stocks, commodities, emerging market debt and higher-yielding currencies will remain until the stimuli fade.

"It would be too early to expect a major correction because the fiscal impulses are still at work" said Klaus Wiener, head of research at Generali Investments.

"I would expect a 'reality check' when those impulses run out. In my mind, that is most likely to be late fall, early winter" he said.

But there are few investors who expect a correction, whether it comes now or later, will take stocks back anywhere near the depths of 2008 and early 2009.

BlackRock's Doll, for example, is only looking for "continued volatility and occasional setbacks" while Wiener says the market lows were the result of fear of a systemic financial crisis, now passed.

That does not mean days like Monday will not continue to set off jitters among investors who have seen quite enough of them over the past two years.