KEY POINTS:
Mervyn King, the Governor of the Bank of England, expressed surprise last month that the UK stock market had been rising since August, despite the "stresses and strains" of the credit crunch.
"There must be some downside risks from that ... I think it's that sort of risk which is the bigger risk to the world economy than the narrower one focused on the banking sector," he said.
There has since been a litany of bad news, including a warning from the UK's Financial Services Authority (FSA) that mortgage lenders are in for a "very difficult" year as more than a million borrowers face a sharp rise in rates; a growing number of companies warn about their prospects; and the US authorities start an investigation into Wall St banks over sales of sub-prime mortgages.
And speculation of yet more bad news abounds: Last week, David Buik of Cantor listed 10 rumours sweeping the market, ranging from the imminent collapse of a housebuilder and a handful of hedge funds, to the bailout of a major European bank. Yet despite all this, London's FTSE 100 index and the Dow Jones in the US have both risen a further 100 or so points.
King's actions have proved more influential than his words: his quarter-point cut in base rates confirmed to investors that the authorities will come to their aid, just as they did after the technology bust seven years ago.
The Federal Reserve is expected to follow suit next week - indeed, optimists think it could cut rates by half a point - and the European Central Bank and even the Bank of China are expected to reduce the cost of borrowing over the coming months. That, so the theory goes, will stop the collapse in consumer confidence that could spell disaster for the economy.
In fact, as Andrew Milligan, head of global strategy at Standard Life Investments, points out, the Bank of England's base rate has become largely irrelevant to the banks.
The three-month Libor, the rate at which banks lend to each other, is at 6.65 per cent, or more than 1 per cent above the reduced base rate; sub-prime loans have become virtually impossible to arrange; and, as Bradford & Bingley said last week, the number of buy-to-let loans available has fallen by 40 per cent.
"The Bank of England is just beginning to offset the monetary tightening, we are not seeing monetary easing," says Milligan.
He is gloomy about the outlook for markets next year, despite the fact that the banks are coming to the rescue.
"This is not 1998 [when the Russian debt crisis sent tremors round the markets], when a few interest-rate cuts removed the damage and the pain."
Mike Lenhoff, chief strategist and head of research at Brewin Dolphin, notes that, despite King's observation, there has already been a severe crash in some sectors of the stock market: property company shares have lost more than 40 per cent, while banks, housebuilders and general retailers have seen a quarter or more wiped off the value of their shares.
But the impact of these falls has been masked by a stellar performance by mining, telecoms and utilities.
Earnings forecasts have fallen. At the start of October, US analysts were expecting an 11.4 per cent rise in profits for the fourth quarter of the year; already that has been slashed to 1.2 per cent, and Lenhoff expects estimates for next year to fall sharply too.
"That is why interest rates are going to be cut." He does not think that the downgrades are necessarily bad news for share prices, because valuations are still relatively low: US-market shares are priced at roughly 16 times expected earnings for 2008, around the long-run average, while the UK is on less than 13.
"This is a not like the dot.com boom, when valuations were much more of a problem," he says.
Edward Bonham Carter, chief investment officer at Jupiter, agrees that earnings downgrades are likely.
But he points out that alternative investments are looking less attractive too - property is falling, cash interest rates are declining and corporate bond defaults are likely to rise.
Others have become more gloomy. Morgan Stanley's Teun Draaisma thinks there is now a 45 per cent probability of a 3 per decline in markets over the next 12 months - and a 35 per cent chance that the collapse will be a much more painful 19 per cent.
The final outcome for stock markets next year will largely depend on whether the US avoids recession. The gloomiest forecasters think a recession is inevitable as lower house prices, higher fuel prices and an effective lending freeze take their toll on consumer confidence.
Others, such as Simon Ward, economist at New Star, point to employment data being rather better than expected. "The odds have shifted in favour of a soft landing, with a probability of 60 per cent. And if you look at equity markets in previous soft landings, there should be 20 per cent upside from here."
The doom-mongers dismiss this as optimistic. One points out that corporate profits are at an all-time high, so are likely to fall sharply. Anyone with a pension or other equity-based investment will hope he is wrong.
- Observer
