The London market is in cardiac arrest

The patient is not responding. Liquidity infusions, co-ordinated rate cuts, state-sponsored bank bail-outs – nothing seems to be working. The London market is in cardiac arrest.

Yesterday, the FTSE 100 plunged a further 8.9 per cent, extending losses over the week to 21 per cent – its worst run since the stock market crash of 1987. The blue chip index has dropped 41 per cent from last June’s high and closed at its lowest level since May 2003 last night. Only the bear markets of the 1970s and 2000-03 have been more severe.

So why is the market not responding to the medicine? What is driving the selling, when European equities are the cheapest they have been since the mid 80s? And is there anywhere safe to hide?

At the most basic level, the selling is being driven by fear. Faced with apocalyptic headlines, investors are pulling money out of the equity market, and these redemptions are causing hedge funds and investments fund to sell stock almost indiscriminately.

Traders estimate that 2.5 per cent of all US equity mutual fund assets have been withdrawn in the past five weeks.

Over the past couple of trading sessions, much of the selling has been to cover redemptions and traders warn that the further the market falls, the more people will ask for their money back, which in turn will cause more selling and push the market even lower.

There is also no evidence that any of the moves undertaken by the Federal Reserve, Bank of England, or the European Central Bank to free up money markets – the transmission system of global finance, – are working. They remain frozen. Banks are not lending to each other for anything other than the shortest possible terms. Perhaps. the best measure of risk in the interbank lending market is the spread between the overnight index swap rate (OIS) and three month dollar Libor. Yesterday that rose to a record high of 365 basis points.

On top of that, institutional investors are worried that central banks have not responded quick enough to the banking crisis and the best outcome is that the emergency measures prevent a severe recession becoming depression.

On average, global recessions last two years and earnings fall by 25 per cent. This downturn is following a similar path, according to Citigroup. It has lasted 10 months and earnings are down by 9 per cent. However, Citi says that because of the severity of the financial crisis, and the prospect that bank lending is hugely curtailed in the near term, the risk has to be that the earnings downturn is worse than anything witnessed in the past 40 years.

“We are not even close to half way through the UK recession, with the associated job losses, business failures, mortgage arrears and repossessions and debt write-offs. Much of the economic pain still lies ahead,” says Citi.

Of course, if analysts cannot forecast how far earnings will fall then valuations measures such as price/earnings ratios become useless. In any case, liquidity and access to funding is probably more important than valuations right now. However, there are many commentators who think a 1930s style depression is almost inevitable. Among them is Nouriel Roubini, Professor of Economics at New York University’s Stern School of Business. “The world is at severe risk of a global systemic financial meltdown and a severe global depression,” he warned this week.

Against such a backdrop there are clearly few safe havens in an equity market where good companies are being trashed alongside the bad as hedge funds and fund managers are forced to sell. That is not to say investors will not be able to find bargains, which could generate significant gains over the long terms. Take BP and Shell for example. BP offers a prospective dividend yield in 2009 over 9 per cent, while Shell offers close to 7 per cent. And these payments look unlikely to be cut given they are based on the assumption of $60 a barrel oil.

Overall, the London market is no place for risk adverse investors right now. With the western financial system shaken to its foundations, capital preservation is the order of the day and that is probably best achieved by sticking cash in the bank, especially in light of the new government guarantees.

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