The King is dead! Long live the King! With apologies to the Royal Family, this traditional proclamation, which expresses an historic continuity transcending quotidian human events, seems an appropriate slogan for financial markets after the shakeout last week. As financial contagion spreads from mortgages to private equity to takeover credits, it is clear that the bull market of 2003-07, driven by reckless borrowing and careless lending, is over. What is less obvious is that the death of the old bull market could clear the way for a new bull market in high-quality companies with solid profits, strong balance sheets and no need for external cash. While this new bull market may not be quite as young and energetic as its predecessors, it should still be able to enjoy a long and prosperous reign (think of Prince Charles when he becomes King Charles III).

The fact is that bull markets, like royal dynasties, do not just die of old age. Neither do they expire for everyday reasons, such as a change in risk appetites or a corporate bankruptcy or two. As this column has repeatedly argued, the long-term trend in asset prices will change from up to down, when — and only when — one of three conditions is satisfied. The global economy must move into recession, decimating corporate profits; or interest rates on government bonds must rise sharply, to well above the long-term economic growth rates; or stock markets must get so overvalued that equity prices start to fall of their own accord, even without any pressure from high interest rates or weaker profits. At present, none of these conditions is satisfied for broad stock market averages in most leading economies — even though there are plenty of over-hyped shares that have risen far above any plausible fundamental values on takeover rumours or hopes.

Many of these “whisper-stocks” may now fall much further, as investors move towards a more rational assessment of credit risks. But, in the absence of some major change in the macroeconomic environment isn’t it likely that the losses among takeover candidates will be offset by gains among stable large-capitalisation companies which investors have, until recently, been neglecting, because they were too big or too successful to be bought out?

To try to answer this question, let us consider the main arguments offered by the bears who emerged triumphantly from hibernation over the weekend, declaring that the stock market collapse which they have been continuously predicting (in some cases since the early 1980s) had finally begun. Three main reasons are offered for the belief that last week’s shakeout in credit would trigger a much more serious bear market.

First, stock markets are said to be overvalued because of the takeover premiums attached to all companies which could conceivably be subject to a leveraged buyout — and as these premiums vanish, stock markets will surely collapse. I agree that many LBO premiums will now evaporate, but I see no reason why this should hurt companies that were never valued on the basis of takeover hopes. Many solid companies — especially ones with market capitalisations bigger than the $30 billion limit for LBOs — have suffered big discounts because investors were interested only in searching for the next takeover targets. Now these discounts should disappear, just as the discounts on “old economy” industrial and property stocks disappeared early in this decade after the bursting of the technology bubble.

Secondly, it is argued that Asian and Middle Eastern central banks and sovereign wealth funds will recognise their folly in providing easy financing for leveraged private equity bids. As a result, oceans of liquidity will be drained from Western stock markets, contributing to the inevitable collapse. Again the premise is probably right, but the conclusion does not follow. It is true that asset prices around the world generally have been buoyed by liquidity created by reckless banks and credit market lenders, including hedge funds, pension schemes and sovereign wealth funds. The bears believe that this liquidity will be drained out of the equity markets as hedge funds go bust, bank balance sheets are decimated by credit losses and institutional lenders realise that they have been taken for a ride. I am not convinced. While I believe that there will be less money available for leveraged transactions, there is no reason why overall flows into equity markets should dry up. As long-term investors cut down (or eliminate) their allocations to high-risk buyout lending, the money flowing directly into equities will correspondingly increase. But the money will enter stock markets through the front door of large-cap equity investment instead of on the back of leveraged financing for LBOs. Moreover the Asian and Middle Eastern government funds that may now take over from hedge funds as the most influential stock market players, will not be seeking instant profits from quick takeover bids. They will be looking for large, stable companies that can absorb multibillion-dollar investments and will stay in business for many years generating steady growth of 10 per cent or so. These are exactly the sort of companies that have been ignored until recently by equity investors and which now offer unprecedented value for long-term investors.

Finally, the bears contend that falling asset prices and receding liquidity will aggravate the troubles already evident in the US housing market and condemn the US economy to a long period of stagnation. Some even predict a Japanese-style vicious circle of defaults on leveraged transactions, widening credit spreads, imploding bank multipliers and more liquidation of balance sheets. The problem with this argument is that all the economic indicators point the other way. The US economy has passed its low point and while we do not expect it to return to trend growth of 3 per cent plus for another six months or so, all leading indicators suggest that a gradual acceleration is under way. But suppose this is wrong and the financial shakeout really does hit consumer or business confidence. If this happens, it will also reduce inflationary pressures and give the Fed even more leeway to ease than it already enjoys. The US Treasury bond market has already reacted to the credit debacle by lowering ten-year rates from 5.3 to 4.8 per cent and by pricing in a high probability of the Federal Reserve Board cutting interest rates before the end of this year. If investors get any confirming hint of Fed easing, assets with strong long-term growth prospects such as high-quality growth stocks and Asian infrastructure plays should really take off.

In sum, I believe that the liquidity crisis seen today has very important implications but they are not the ones identified by the bears. The withdrawal of excess liquidity will cause a big shift in relative prices within the equity markets and big losses for investors in poorly structured leveraged deals. But this need not be bearish for equity averages and could be very positive for high-quality companies and markets, which have been left behind by the fads for issuing junk bonds and repackaging low-quality assets. So the old bull market is dead; but the new one may be just starting.

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