Some big threats to share prices have cropped up recently, making a foolish writer fearful...
Last week I highlighted the dangers of collateral damage from the US sub-prime mortgage market and suggested this could cause a 'credit crunch' which could knock asset markets over here.
As one of the Fool's resident contrarians I admit to being always on the lookout for reasons why high-flying markets might fall. Sometimes prophesies of doom can be too early. Markets can overshoot in 'irrational exuberance' mode as famously described by former US Federal Reserve Bank chairman Alan Greenspan. Bull markets climb a wall of worry and finally only turn down when the last bear gives up.
But there are now three reasons why I believe London share markets are topping out and are vulnerable.
1. Global credit jitters could spread to equity markets
An apparently unending supply of cash has driven up global asset prices for several years. Now credit is tightening up as the interest rate 'spread' between lower quality debt and government bonds rises. (In other words, risky borrowing has become more expensive.)
Stock market corrections historically follow debt cost increases by some six months, according to market watchers Morgan Stanley. They saw 'spreads' begin rising in February and believe global stock markets could drop next month.
Morgan Stanley's "value indicator" shows the median European stock now selling at a record high price/earnings ratio of near 20 times: "Shares have reached all-time highs despite higher interest rates and oil prices, wider 'spreads' and a weak dollar. It looks similar to the relentless rise in 'spreads' from February to September 2000 when stock markets tipped over."
2. UK profit warnings are at their highest since 2001
In the first half of 2007 191 companies cut earnings forecasts, 13% more than in the same period in 2006 and the largest number since 2001, according to accountants Ernst & Young last week. A sales shortfall was the most often quoted reason for warnings with higher borrowing costs also causing problems.
Worst affected were software firms and support services. Retailers remained under pressure, with twice as many profit downgrades in the second quarter of this year than for last year as the squeeze on consumers' discretionary income hit big-ticket and discretionary sales.
Ernst & Young says the UK cannot now rely on the subdued inflation, fast growth and low interest rate combination of the last few years.
3. 'Leverage'
In other words, shares bought on borrowed money or by using derivatives. Remember that rising interest rate 'spread'? It also raises the cost of money for leveraged buyouts where investors, often management, buy companies with big debt backing.
In 1989 shares were buoyed up by leveraged buy-outs and property prices were sky high. In 1990, the buy-outs unraveled, house prices slumped and the FTSE All-Share index fell 14%.
When hedge fund Long Term Capital Management collapsed in 1998, having borrowed heavily from investment banks, the dangers of excessive leverage became clear when stocks crashed over 20%.
Fast forward to 2007, and it feels like déja vu. The FTSE 100 is driven by leveraged private equity deals and property prices are sky high again.
I've also been looking at the opaque world of derivatives. A worrying dearth of information is available. The London Stock Exchange has no definitive numbers but believes that CFD (contracts for difference) trades account for as much as 40% of total market deals.
Basle-based Bank of International Settlements only provides slightly out-of-date European figures which confirm that between December 2005 and March 2007, the value of equity index futures and options trades more than doubled as European markets rose less than 20%.
Policy makers don't know how much leverage is in the system today. But it feels high and rising as shrinking investment returns have pushed investors into leveraging up, which has cut returns even lower.
So what should investors do who want to stay in the market?
My answer: move into large blue-chip companies on relatively cheap price/earnings ratios.
With liquidity tightening, capital intensive industries tend to underperform. Commodity prices speculators cut and run. Companies that depend less on debt are likely to outperform those with high borrowings and poor interest cover.
Areas that tend to outperform during rocky periods are high quality bonds, big companies and defensive sectors like healthcare.
This is not scaremongering. Property and share markets have risen a long way and contain a lot of unrealized profits. Some very significant threats have emerged recently.
Ultimately it's your decision about what, if any, action you take. Just remember that market falls can happen fast, and afterwards it all seems so obvious...
More: How I Time The Market
