The Sky Isn’t Falling—Yet

With global financial markets in the midst of another panic attack, investors would do well to consider the calming words of that beloved children's character—and overlooked philosopher—Winnie the Pooh. In response to the frantic question "What if the sky falls on us?" Pooh turns around, smiles and says: "What if it doesn't?" At this advanced stage of a bull market, investors typically have a rather sanguine view of the world.

Yet a remarkable feature of the current bull market in global stocks—one of the longest and most powerful in history—is that financial analysts are spending more time worrying about unwelcome developments that could end the party than basking in the upswing. This year the concerns revolve largely around the woes of the U.S. credit market, but in the past few years there has always been something to fray nerves in the marketplace, from high commodity prices to the U.S. current-account deficit.

Through it all, the bull market has climbed one wall of worry after another, with the global economy reveling in its best spell in postwar history. That hasn't stopped the financial commentariat from fretting. They now worry that the interest-rate cuts by the Federal Reserve are doing little to boost a debt-laden U.S. economy, but are instead creating bubbles in other parts of the world, including in the superhot stock market in China. Given these ongoing concerns about the fragility of the bull-run, it's worth examining what could in fact bring about an end to this bull market—and what could not.

For one, bull markets don't just die of old age. A catalyst is required to precipitate a downturn, and historically, only one factor has terminated bull runs: rapidly rising interest rates. Bear markets occur when earnings collapse due to an economic recession, which in turn is brought about when real interest rates cross the threshold of pain. From the Great Depression of the 1930s to the East Asian crisis of 1997–98, all major market declines have taken place against the backdrop of an aggressive monetary-policy stance. In developed economies, central banks raise rates aggressively when they are trying to contain inflation or attempting to prick an asset-market bubble. In emerging markets, central banks act for those two reasons and one other: in the past, they have often hiked rates to prevent their currencies from weakening. These days, key emerging markets are battling to keep their currencies from appreciating too rapidly.

So then the question, of course, is whether the central banks have any reason to get aggressive in the foreseeable future. Right now, the Fed is moving in the opposite direction, lowering interest rates in response to the credit crunch, which it can do because inflation is so far well behaved. But there will come a stage in the current cycle when inflation begins to rear its ugly head. At that point, central banks will have no choice but to raise interest levels, even in the face of higher debt levels, which will truly mark the end of the party.

In China, inflation concerns are rising, with prices for food in particular increasing. However, the central bank does not target food prices, as it believes temporary supply shortages in some agricultural products, rather than low interest rates, are primarily responsible for food inflation. And with inflation minus food prices still tame, the authorities have so far taken only incremental steps to tighten policy.

There's another perceived risk in China. The growing view in the financial community is that the Chinese stock market is in "bubble" territory. With the Shanghai Composite Index up nearly 500 percent since its bottom in July 2005, these concerns can't be dismissed out of hand. But they are impulsive. Badly burned by the tech boom-bust cycle earlier in the decade, investors have been on "bubble watch" ever since. Financial commentators are too quick to dub any sharp asset-price increase a bubble.

A look at past market manias shows that bubbles usually tend to peak when average stock prices reach the level of 50 to 60 times projected earnings for the coming year. At least by this measure—the price/earnings or P/E ratio—China's domestic stock market is not in bubble territory yet, with its P/E ratio at about 35. Big bubbles of the past few decades, such as the NASDAQ in 1989 or the Hong Kong market back in 1973, all reached much loftier heights, with P/E ratios peaking at about 55. Even then, it took determined tightening by central banks to burst those bubbles.

The odds, then, favor a continuation of the broad bull market in stocks, with the fast-growing emerging markets lead-ing the way. The feeling of impending collapse will make way for an ever-rising sense of comfort with higher stock prices. But currently the markets are still some distance away from such a point. If history is any guide, the time to be truly concerned about a bear market will be when central banks have little option but to raise rates to ward off inflation, even if economies are slowing. We're not there yet.

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