Over the past week, global stock markets have remained volatile with most of the end of last week’s gains given back in the U.S. following renewed fears that stockholders will lose everything in a government-led recapitalization of Fannie Mae (NYSE: FNM, Stock Forum) and Freddie Mac (NYSE: FRE, Stock Forum). Despite the volatility, we continue to believe that great value is now beginning to emerge in the stock market, particularly in some specific sectors. However the central question for investors continues to be whether the markets have bottomed.  

"With $1.5 trillion in reserves, nothing will deter China’s centrally planned leadership from altering course, and more importantly, they now have the cash to pay for the next 20 years of infrastructure development."  

Although we believe the market is nearing a climactic bottom, it is highly likely that ongoing volatility will persist and we could see equity indices have another downward leg before a final low is in place. 

One reason for recommending that caution be exercised is the recent contraction in U.S. money supply, where, according to data compiled by Lombard Street Research, M3 (the broadest definition of money supply) dropped by almost $50 billion in July, which represents the biggest one-month fall for a number of decades. 

The M3 data measure can provide an early indication of future asset prices, which could signal that there is further downside risk to the U.S. and global equity markets in the months ahead. International stock markets are still heavily influenced by sentiment on Wall Street and are therefore subject to the ongoing leash effect. 

Taking a broader perspective and looking out to the medium term (which we define as beyond the next six months), we believe the picture will improve and our outlook is more positive. After maintaining firm monetary policies in light of inflation, most central banks around the world are now grappling with a potential slowdown in the world economy. In the past, central banks (with the exception of the Federal Reserve) have raised interest rates at the first signs of inflation.  

We believe, however, that for the most part, central banks are set to change course and become much more accommodating with inflation in the pursuit of maintaining growth. In other words, we will shortly witness synchronized reductions in interest rates, which will at some point have a positive impact on valuations and prove to be a tailwind for stock markets.  

While other central banks should begin reducing interest rates before the end of the year, it is highly probable also that the Federal Reserve will not only keep the Fed funds rate low for a considerable time, but at some point resort to implementing reflationary policies.  

Until the rate cuts are implemented, equity markets will likely remain volatile for a few more months yet. Having said that, we believe that the rate of the declines witnessed over the past year will likely begin to slow. In many cases, some equity markets (like India) may have already bottomed out. 

Our strategy continues to be biased towards large-cap stocks, which tend to fair better during bear markets and times of volatility. Against this backdrop, we continue to prefer defensive industrials such as the telcos, resources, precious metal and energy sectors, despite the recent downside price action, as well as large multi-nationals that bring diversified international exposure. There is abundant value now emerging in these sectors. 

Internationally, financial stocks are looking more attractive from a valuation perspective, but sentiment still remains extremely pessimistic and continues to overhang the sector. Fundamentally, it is difficult to determine whether this sector has yet made a final low while bad news continues to come forward.  

From a technical perspective, the chart below illustrates the story in America thus far. After losing some 55% in value between May 2007 and July 2008, the S&P 500 Financials Index staged a solid rebound in excess of 35% in late July. Although this rebound marks an encouraging pause in the broader bear market, the gains are already being eroded. 

In our opinion, it is too soon to declare an end to the bear market in financials. With the downward trend remaining intact, further falls remain a clear possibility in the months ahead. 

As such, we believe that a further, sustained break above 310 on the index is needed to signal an attempt to restore upward momentum and shift focus back to the 377 region and above. 

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