Jim Jubak

Jubak's Journal1/22/2008 4:00 PM ET

Where the bear will bite hardest

Gone is the notion that red-hot markets in China and India can keep the global economy from cooling. Next, expect some bear rallies, but don't be fooled by them.

By Jim Jubak

The last bull market myth still standing is now dead -- at least in the minds of the many investors who believed that China and India could continue to power the global economy despite a slowdown or recession in the United States.

The panicked sell-off in overseas markets on fears of that long-anticipated U.S. recession is proof of the theory's demise.

The death of this belief in "global decoupling" is likely to have three effects:

  • It will shift the harshest bear market action from the U.S. to overseas markets, as overseas investors discover that their economies are slowing, too.

  • It raises the odds of a "bear market rally" in the not-too-distant future. Such a rally would leave the bear market intact and end in another painful market downturn.

  • And though the death of this myth is essential to finding the bottom in the current bear market, the final end of the bear still depends on a recovery in the U.S. financial and housing sectors, which now looks unlikely until early 2009.

The danger of slowing economic growth is a months-old story to U.S. investors -- one reason that the major U.S. market indexes are currently flirting with the 20% loss that defines a bear market. But it's something new for investors in overseas markets, many of whom thought that those economies would be immune to a U.S. recession.

Global panic

Signs of slowing growth in Europe and Asia -- even in China -- have been enough to set off panic selling in those stock markets. Japan's Nikkei 225 Index ($N225) plunged 5.7% to 12,573 Tuesday after shedding 3.9% Monday. Hong Kong's Hang Seng Index ($HSI) plummeted 8.7% Tuesday after falling 5.5% Monday, and India's Bombay Stock Index slumped 5% more after slipping 7.4% Monday.

Things were brighter Tuesday in Europe, where London's FTSE 100 Index ($GB:UKX) was up 2.9% after falling 5.5% Monday and France's CAC 40 Index ($FR:PX1) was up 2.1% after shedding 6.8% a day earlier. Germany's Dax Index ($DE:DAX) was down just 0.3% after plunging 7.2% Monday.

The panic in Europe was relatively short-lived because the experienced institutional investors in that market expect the European Central Bank to intervene with interest-rate cuts to stabilize the market just as the Federal Reserve did in the United States.

The situation is much different in the newer stock markets of China, India and the rest of the developing world. There a wave of new individual investors had driven stocks up to much higher valuations. Stocks in Shanghai, for example, traded at a price-earnings multiple of 50 in mid-2007, when the Standard & Poor's 500 Index ($INX) traded at a multiple of 17. A slowdown in growth takes a much bigger bite out of a stock trading at 50 times earnings than out of one selling for 17 times earnings.

New investors, meet the bear

The real danger in these new markets, though, is that no one knows how the inexperienced individual investors who have flooded into these markets will behave when their stocks start to fall. For example, Chinese investors opened more than 35 million brokerage accounts in 2007. Most of the owners of these accounts -- and of new accounts in India, Russia, Brazil and the rest of the developing world -- have never experienced an extended market downturn.

A panic like the one the overseas market produced Monday and Tuesday starts visions of a bottom dancing in investors' heads. Especially when that panic is accompanied by a reversal in the U.S. markets. Before Tuesday's open, the futures market projected that the Dow Jones Industrial Average ($INDU) would open down 440 points. But the index quickly shook off that level and began to move up until, at 1:30 p.m. ET, it was down just 100 points. It closed down 128 points.

Video on MSN Money

Gold prices © Stockdisc / SuperStock
A shining turnaround?
It looks like the market may be falling for the next six to eight months. Even gold, a traditional haven, is taking a licking. But gold will likely come back before stocks do, says MSN Money's Jim Jubak -- because buyers will return to the jewelry market as prices drop.

I wouldn't be surprised to see the market attempt a rally off that level. After all, just as bull market advances are punctuated by market declines, so too are bear market falls interrupted by rallies. The speed of the decline in the U.S. market -- 20%, more or less, from the October highs -- argues that we'll get one of those bear market rallies in the not-too-distant future. Especially because the U.S. Federal Reserve's surprise 0.75-percentage-point rate cut before the market open gave investors something to hang a rally on.

Premature optimism

You can see the likely shape of such a rally in the list of winners and losers in the first half of the trading day Tuesday. Stocks with a big exposure to U.S. interest rates went up. Merrill Lynch (MER, news, msgs) had climbed 3.6% by midday. Home builders Pulte Homes (PHM, news, msgs) and Lennar (LEN, news, msgs) were up 4.8% and 1.2%, respectively. Heavily domestic U.S. companies such as Deere (DE, news, msgs) and Watsco (WSO, news, msgs) also rose.

On the other hand, stocks with big exposure to the global economy, such as mining-equipment maker Joy Global (JOYG, news, msgs) fell, as did just about any oil company you can name.

Continued: Beware of joining the rally herd

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