When analysing financial markets, it’s important to also keep one eye on the economy, because financial markets are not the same as economic markets. In financial markets, there is only one consistent measure of value: price. However, in economic markets the measure of value is more subjective, and is contained in the question “How well is the economy doing?”. To answer it, analysts use a variety of indicators such as GDP, exports, industrial production, consumer price index etc. etc.

At uncertain times like this, being able to analyse the economy can sometimes provide a sane benchmark against which to asses whether things are overvalued or undervalued. This is because a large component within financial markets is “expectation”. Put simply, investors will pay more for a company if they expect it to do well in the future regardless of what it currently says in the company’s financial statement. There is no such thing for economic indicators, which only look backwards.

So if you look at our current economic indicators, there is actually quite a lot to feel comfortable about, because both Industrial Production and International Trade has been growing steadily in 2007 (thanks to our palm oil), and at the global level even though the US may be in a recession, high commodity prices and exports are providing evidence that emerging markets are slowly starting to consume more and more goods, thereby taking up the responsibility of becoming the world’s consumer and keeping demand alive.

The question we have to ask then, is if that is the case then why are financial markets in distress? Well, it began with the credit crisis - a phenomenon which would theoretically have been confined to financial markets, were it not for the fact that it happened on such a grand scale that it is affecting the ability of banks and creditors to lend money to mom and pop - retailers and other bricks and mortar businesses.

On top of that there is also the (separate and more worrying) fear of inflation, caused by high commodity prices driven partly by a weak dollar and partly by surging demand in the emerging markets. The fear here is that inflation will cripple the ability of the emerging economies to continue demanding more goods, thereby causing more businesses to suffer and result in a depression.

As a result, investors are staying away from the financial markets and causing weaknesses in share prices, and thus the conclusion is that even though the economy can be said to be chugging along just fine, fear has caused financial markets to disconnect from the economy, because it expects the economy to suffer and for economic indicators to turn down in 2008.

What I have just described are the first phases in a bear market cycle, which has several phases each characterised by its own specific brand of fear. The first type of fear is a knee-jerk reaction, usually starting from a single event (such as the the poor results from banks resulting in writedowns and the sub prime fiasco) which then spreads to a second type of fear of something more fundamental (such as fears of liquidity and inflation worries). As traders, we will start to consider whether the end of the cycle of near when market fears which reach such deep levels.

But be careful, because it’s important to understand what we mean when we say that the end is near because firstly just because the end is near doesn’t mean that there will be a bull anytime soon. And secondly just because we are near doesn’t mean that there can not be a further drop in prices. As traders we need to wait for evidence of a turnaround - which will be the subject of another post.

So my opinion is that there is one more fear to come, and that is when we look at the most recent evidence that emerging market economies are slowing along with exports (China’s industrial production figures and imports are already down in 2008) and people start to expect both the US and China’s economies to stall. But, that won’t come quickly because there will be bear market rallies every now and then as the Fed and other central banks and governments take whatever measures they can to avoid this possibility and making it extremely difficult to pinpoint the exact moment when the market bottoms.

So, I still intend to gradually start accumulating shares over the entire period of the market bottom, and eventually going into 100% equities.