Increasingly bullish estimates say the chances of a double-dip recession are about 20%, writes PROINSIAS O'MAHONY

NEVER HAS the adage that bull markets climb a wall of worry seemed more appropriate. This year was dominated by talk of double-dip recessions, serial sovereign debt default and the possible demise of the euro, so much so that ordinary investors are likely to be surprised by the magnitude of global market returns.

The SP 500 advanced by more than 10 per cent this year and has finally returned to pre-Lehman levels, even if it remains well shy of its 2007 high. High-yielding dividend stocks did well but the main outperformers were less illustrious names – junk-rated stocks enjoyed returns three times as great as the most stable names with high credit ratings, while stocks with the highest price-earnings ratios easily outpaced the market’s cheapest companies.

It was a year for growth rather than value, with small and mid-capitalisation companies returning double the gains of large-cap blue chips, a phenomenon that was replicated globally. Most developed markets enjoyed similar returns, while emerging-market funds did even better, rising by 17 per cent.

Despite the solid gains, markets were very jittery throughout the year. China, despite replacing Japan as the world’s second-largest economy in 2010, saw its stock market plunge by 32 per cent from its 2009 peak before bottoming in July, when it staged a strong comeback to end the year only slightly lower.

Japan, too, fell into official bear market territory (a fall in excess of 20 per cent) before staging another late rally.

The SP 500, having raced ahead from 1,040 to 1,220 early in the year, suffered its infamous “flash crash” in May, falling by 9 per cent in a matter of minutes. By July, investors were in the red but they enjoyed the best September since 1939. It has been one-way traffic since then and the index hit new highs in December, a pattern mirrored in the UK, with the FTSE’s sizable gyrations testing investor nerves.

Unsurprisingly, European returns were less stellar. Germany’s DAX 30 reclaimed the 7,000 level for the first time since 2008, advancing by 17 per cent, but the EuroStoxx 50 fell slightly. France’s CAC 40 was flat and the so-called PIIGS – Portugal, Ireland, Italy, Greece and Spain – were pummelled (with a decline of more than 40 per cent, while Greece’s stock market was one of the worst performers in the world).

Investors cannot say that Europe’s sovereign debt woes were not well-flagged. Greece’s dubious accounting techniques have long been the source of raised eyebrows, while the well-publicised work of celebrated economist Kenneth Rogoff had made clear that financial crises are almost always followed by sovereign debt crises.

Nevertheless, investors were taken by surprise when the Greek panic took hold in the spring. Bond yields widened dramatically amid increasing concern over debt levels and government deficits, and talk of contagion flattened markets everywhere. Europe’s leaders lined up to blame market speculators and even what the Spanish referred to as “the aggressiveness of some Anglo-Saxon media” for the crisis in a shoot-the-messenger mood eerily reminiscent of 2008.

A €110 billion loan for Greece was eventually agreed, while an emergency fund for troubled European states, the €750 billion European Financial Stability Facility, was also created.

Euro zone debt fears continued to fester, however, with Ireland and Anglo Irish Bank soon occupying centre stage. “Can one bank bring down a country?”, the New York Times asked in September. “Yes”, the markets replied, with bond yields soaring after the Government’s admission that the Irish banking bill was likely to hit €50 billion.

Ireland’s broken banking system was effectively nationalised, the cost of insuring against Irish debt default hit levels exceeded only by a handful of economic basket cases and a controversial €85 billion aid package was eventually agreed after the ECB tired of funding Irish banks. Fears of contagion remain, however, as shown by bond yields in Portugal and Spain.

Nevertheless, global stock markets, so spooked last spring at the thought that Greece might be “Europe’s Lehman”, proved more resilient during the Irish crisis. In the US, analysts have been buoyed by continued strong growth in earnings, with company “beat rates” remaining at historically high levels.

The earnings have been driven by cost- cutting and profit margin expansion rather than strong revenue growth, however, with the US economic recovery remaining a jobless one.

High unemployment was not the only concern. By summer, talk of a double-dip recession was growing. Economic growth figures were being revised downwards, leading indicators were deteriorating rapidly, many stimulus measures had expired and commentators were warning that the Federal Reserve, having already slashed interest rates to rock-bottom, had run out of ammunition.

Or maybe not. Miserable investor sentiment surveys and extremely oversold technicals hinted that markets were poised to rally if a catalyst emerged. Improving economic data helped, as did Federal Reserve chairman Ben Bernanke’s decision to undertake a second round of quantitative easing that will see the US pump another $600 billion into the economy.

QE2, as it has become known, has its opponents. Domestic critics say that the extra liquidity created will not tempt already debt-laden consumers to borrow and will merely fuel dangerous asset bubbles; international critics, particularly in China, warn that the US is deliberately driving down the dollar and risks fuelling currency wars. The US, meanwhile, continues to be irked by China’s refusal to allow the renminbi to appreciate significantly.

Trade frictions have been overshadowed by euro volatility, however. The single currency, worth $1.45 in January, fell to $1.20 as the Greek crisis raged, subsequently retraced all its losses as market attention turned to US policies, and then fell back below $1.30 during the Irish meltdown.

Nevertheless, market reaction to QE2 has been positive and a raft of better-than- expected economic data has largely killed off talk of a double-dip recession. Even Nouriel “Dr Doom” Roubini now reckons the odds of recession have diminished to just 15-20 per cent. Consensus analyst estimates project similar gains for markets in 2011 and sentiment surveys show a marked increase in bullishness.

To bulls such as Goldman Sachs’s Abby Cohen, this confidence is justified. Others, such as Société Générale’s Albert Edwards, assert that the notion of a sustainable economic recovery is “as ludicrous as it was in 2005-2007”. Cohen argues that US markets, trading at 13 to 14 times earnings, are “significantly below the historical average”.

Value investors such as Jeremy Grantham, however, say that while momentum may carry markets higher in 2011, long-term valuation metrics that smooth earnings over the economic cycle reveal a significant over- valuation. Many bulls and bears agree, however, that high-quality blue chips, which have underperformed throughout this bull market, have room to rise.

Many of the issues that occupied market minds in 2010 – the US economic recovery, earnings growth, euro zone debt fears, fiscal and monetary policy in China – are likely to do so again in 2011, with investors hoping for a third consecutive year of market gains.