Waiting for the market tumble

It should therefore be a cause of concern to equity investors that while share markets have been enjoying a rally in the past few days, debt markets look as sick as ever, because the only explanation for debt markets being so sick is that they know how bad it is now and how much worse it is likely to become. The suggestion that we are past the worst, which is what drove shares higher last week, is met with a hollow laugh.

It is tempting to think that the debt markets are overdoing the gloom, and possibly they are, but consider the following argument. Even if you cut by half the default rate implied by the current price at which debt is selling - and even if you claw back half the current discount on debt, typically trading at between 70 and 80 cents on the euro, or dollar - the debt markets would still be signalling that share prices are much too high. Even if debt markets have got it wrong, they are a lot less wrong than equities.

This is indeed one of the great paradoxes of our time, because who is doing the buying?

Not the traditional homes for shares in the pension funds, because they continue to be net sellers of equities in general and UK equities in particular. Not the retail investors, because they have been net sellers of mutual funds for some months, and the Isa selling season, which has just come to a close with the passing of the tax year, is by all accounts one of the poorest for some years. Not the hedge funds, surely, because they have just come out of the most gruesome month and are in no condition to buy anything as their prime brokers suck back all their leverage, like the juice from an orange, while clients in growing numbers bang on the door wanting their money back, only to be told in many cases that they will have to wait.

So many hedge funds are becoming forced sellers because of de-leverage and redemptions - at least in the cases where the stuff they bought in the good times can in fact be sold - that they threaten to be a major drag on the market. Some will, of course, survive, but the forecast that two-thirds will fold before the end of the year if current conditions persist no longer looks far-fetched.

Similarly afflicted are the proprietary trading desks of the big investment banks - desks which in effect aped the trades and tactics of the hedge funds. They too have had a gruesome quarter, and the word in the market is that the likes of Deutsche, Morgan Stanley and JPMorgan Chase have all decided to scale things back significantly.

Given that these two groups account for so much stock market activity, it is intriguing that the London Stock Exchange could announce, as it did yesterday, that trading volumes continue to set new records.

The argument for shares at current levels is that they look cheap in earnings terms. But as Andrew Smithers of the economics boutique Smithers & Co pointed out the other day, this is in part at least due to the fact that investment analysts have not downgraded their forecasts.

Corporate budgets for this year were mostly drafted last summer, before people took the credit crunch seriously, and at some time in the next few months more and more companies will begin to strike a note of caution. They can scarcely do otherwise in the United States, where 70% of economic activity is related to consumer spending, and that has been derailed. Similarly in this country, where the bite that is already evident in anything related to housing, finance and the media will spread itself more widely through retail and into the wider economy. Then perhaps the investment analysts, so long the cheerleaders for never-ending bull markets, will realise that their earnings forecasts are way too high.

Interestingly enough, the people rub-bing their hands in all this are the major private-equity houses. They acknowledge that the current generation of funds may not be the best-performing vintage, because they contain a lot of companies bought at high prices which are now proving hard to sell. But they can barely wait for the stock market tumble to come,because it will usher in an era of more realistic pricing where they reckon there will be real bargains to be had.

Several of them are in the process of raising more capital now. These could turn out to be much better investments than the mega-funds of 2005 to 2007.