Share prices have recovered today after last week's big falls. Does that mean the crisis is over?
When I warned last month about the potential fallout from defaulting American mortgage borrowers, I admitted not knowing when it would hit.
Now we know.
But as traders are reportedly forecasting ongoing market turmoil and some of the headlines talk of financial Armageddon, what's the reality?
Well, to start with, let's put recent share price falls into context.
Firstly, the stock market hasn't yet fallen very far. Yes, the headlines made great play of the huge sums involved, like the value of the FTSE 100 share index dropping by over £60bn in Friday, but against the overall FTSE worth of £1.5 trillion, this wasn't exactly disastrous.
Don't forget that the 'Footsie' had plunged to 3500 in February 2003, so an index level of just over 6000 still represents a 70% plus recovery over four and a half years. Looking further back, the main market indicator is still four times higher than after the 1987 'crash'.
And that's without adding in all the dividends.
Secondly, this is for the moment a US engineered problem.
Even though UK and European banks may have bought into the train wreck that is the American home loan industry, for the moment our own economy appears just about OK. Not necessarily trouble free, because strains are starting to show in British housing and personal debt, but UK Plc looks sound enough.
Thirdly, it does show what globalization is all about. A panic over the US housing market may show itself anywhere in the world. What the American home loan debacle has done is to make banks round the world much more nervous.
And also to make investors much more nervous about banks.
We tend to assume that all lending institutions are rock solid. Not true. If a bank's loan book, i.e. its asset base, starts going bad, confidence erodes quickly. That bank soon has to pay significantly higher money market rates to fund its balance sheet.
In fact there were so many nerves that last week both the European Central Bank (ECB) and to a lesser extent the US Federal Reserve (Fed) pumped a massive amount of temporary cash into the system in order to bring down interbank rates that had started to soar.
That for now has successfully lowered the market temperature.
Is the panic all over?
With all this doom and gloom around, there's almost certain to be a very short-term bounce in share prices. It's happening today.
Even if this proves to be a proper bear market, shares will spend more time actually going up than they will going down. (It's just that on the bad days, shares fall a long way).
But don't get fooled by the rebound. We live in very volatile times. Again, in previous articles I have written about market leverage, in short, shares bought on borrowed money. We simply don't know how much leverage there is in the market. But I'm willing to bet there's been a bit more than we thought.
This widespread use of leverage means that we may be at the beginning of a bear market that could last for months or years. After all, over the last couple of years share prices have been driven up by private equity buyouts that were only possible due to banks' willingness to lend at low rates.
Some banks have been badly burned by recent events and will be much less likely, or indeed able, to hand out loans as easily as in the past. So the current 'credit crunch' will probably reduce buy-out activity.
And the effects will take a long time to filter through the system.
Of course, bulls would argue that official interest rate cuts would help the markets recover. But I don't believe we're going to see central banks chopping rates soon.
That's because rate cuts would give the wrong message to imprudent lenders -- they would deduce that regardless of their lax lending criteria, there's always a bail-out round the corner.
Indeed markets used to be confident that former Fed chairman Alan Greenspan would, despite his rhetoric, always cut rates and throw liquidity at the markets in an emergency. But there's a different mood about central bankers these days.
The ECB will probably continue hiking rates, at least to 4.5%. Last week's 6% indication from the Bank of England may well not be the peak. And central banks in Australia and South Korea raised rates last week in the middle of the deluge. The Fed might cut rates later this year but because of the housing crisis, not financial market jitters.
Traders now know there are significantly bigger risks in the system and also there that there's no bail-out on the horizon. Dubious financial deals will be hit by both higher borrowing costs and tougher lending conditions.
Eventually economic growth will slow down, which will lead to lower official interest rates, but that's some distance away.
So what's likely to happen next?
Crises often peter out and turn out to be short-term blips. The Asian banking crisis in summer 1998 is a good example, and that could happen again. But my hunch is that this crisis could last for longer.
My concerns are not just the parlous state of defaulting American mortgage borrowers, or even the knock-on effects. I'm worried there could be something worse out there, a 'nasty' we haven't heard about yet but which could shake stock market confidence even further. Share prices may have much further to fall.
That said, remember that sensible equity investment is about the long term. If you choose to use the stock market as a trading casino, good luck. You may make some juicy profits on the market switchback, you may lose your shirt. I believe it's going to be a hairy ride.
At The Fool, we've always advised readers to stay calm and invest for the long-term. And that remains the case now. If you're saving for a pension in years to come or stashing cash on a regular basis in a tracker fund, you should be able to ride out whatever volatility may be on its way.
Sleep soundly in the knowledge that, in the long-term, stock markets as a whole normally go up.
More: Shares Still Beat Bonds | Where Now For Shares? | Money Talk Podcast: Where Next For The Stock Market?
