SERIOUS MONEY:THE WORLD'S capital markets stood on the precipice last week as the credit markets continued to plunge new depths and the risk of a financial system meltdown edged ever closer, writes Charlie Fell

US stock prices suffered their worst week since the outbreak of war since 1914 while the cumulative losses during the first eight trading sessions of October - at almost 23 per cent - surpassed the unprecedented daily drop of "Black Monday" 21 years ago and the carnage incurred during the market break in the same month of 1929.

The percentage decline since the world's largest stock market peaked on October 9th last year came to more than 40 per cent, butchering the long-term returns of pension funds, which have clung to the belief that the great bull market of the 1980s and 1990s is still alive and remains the standard for comparison.

Capitalism reached its darkest hour but, with time running out, a white knight appeared.

Europe, not the United States, advocated a plan that reached the heart of the crisis and, unlike the plans of Paulson and Co across the water, should restore a sense of normality to financial markets and unfreeze the credit markets.

The European plan of action follows those taken by Gordon Brown's government just days before. They realised that the root of the problem could be traced to a shortage of capital and not liquidity, as some in the investment world would have everyone believe.

Massive injections of reserves and the expansion of acceptable collateral by central banks suggests that the concern is solvency and not liquidity.

Banks would not lend to one another for fear of an adverse event affecting themselves or the borrower. Guarantees for inter-bank lending should ease such concerns while capital injections should lead to credit growth, albeit modest.

It is fair to say that the worst of the financial crisis has now passed, even if the worst of the economic fallout is yet to come.

History shows that one-third of the cumulative profit decline occurs before an economic downturn arrives, with the remainder occurring during the recession phase. Given that the developed world has only recently slipped into recession, investors should anticipate further profit gloom. Global corporate profits could drop a further 20 per cent or more.

It sounds bad but stock prices typically look through the earnings valley and have been higher by the completion of three of the four earnings recessions since the early 1970s. However, prices rise if and only if easy monetary conditions overwhelm the profit decline and, during the current period, conditions have remained restrictive despite lower official rates. Should the current plan loosen credit markets, stock prices will climb.

Potential investors should also be aware that equity prices typically bottom two quarters before the end of an economic recession. Given that growth should return during next years second quarter, the market averages should be at or near bottom.

Furthermore, contrarian indicators have aligned themselves in the same direction for the first time in more in almost two decades.

The valuation of stock prices on trend earnings has reached the lowest level since 1990 and, at the market low last Friday, offers long-term real returns of 7 per cent and a risk premium of more than 5 per cent compared with inflation-protected bonds.

Meanwhile, stock prices on trend earnings have dropped below their long-term average for the first time in almost two decades, even though the reduction in taxes and commission costs over time says investors today should expect roughly two additional percentage points in real return to equalise with history.

Valuations are clearly advocating the purchase of stocks but the notion that equities are cheap rarely if ever is the catalyst to propel prices higher. Fortunately, tactical indicators are pointing in the same direction. Bullish sentiment has dropped to the lowest level in decades and the decline in prices below their 50- and 100-day moving averages respectively is only matched by a sharp break on one day in 1987.

Capitulation is evident in the cash flows of US mutual funds. Net liquidation in the year to date amounts to more than $100 billion, with more than 40 per cent of net selling in the past five weeks. As a percentage of total assets, it overwhelms the net selling in 2002.

Stock markets have disappointed in recent times as have the institutions that market their so-called expertise. They will soon cheer up as the second cyclical bear market in a structural downturn is coming to an end. Secular bear markets are multi-year events and powerful contra-trend rallies are typical.

Oliver Stone in his acclaimed movie Wall Street made the current dilemma very clear: "Man looks down into the abyss and at that moment, man finds character. The darkest hour has passed but it's up to you to seize the day."

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