Since the credit crunch started in the summer of 2007, economies and financial markets have swung from one problem to another. We have entered a truly global crisis. John F. Kennedy said: “The Chinese use two brush strokes to write the word 'crisis'. One stands for danger; the other for opportunity. In a crisis, be aware of the danger - but recognise the opportunity.” So how do we balance these opposite risks?

The dangers are easy to see. Global economic conditions deteriorated at a remarkable rate in the final quarter of 2008; financial markets have fallen precipitously. The US equity market was on course for its worst year since 1900. Other asset markets have also experienced historic price dislocations, including commodities (the oil price has fallen roughly 75 per cent since July), the corporate credit market and real estate markets.

The outlook for corporate profits is also challenging. In Europe, for example, we estimate that net income before exceptionals and goodwill will fall by about 20 per cent. Taking the declines seen in 2008, and adding likely exceptionals, earnings per share may well fall by more than 40 per cent from peak to trough for the aggregate stock market and far more in some industries. Furthermore, working capital constraints, exacerbated by the contraction of bank lending, are likely to force more companies to raise capital. Such historic price movements, coupled with the deteriorating economic activity and labour market indicators, make comparisons with the deflationary 1930s in the US, or the “lost decade” of 1990s Japan, very tempting.

Indeed, it is likely that headline inflation numbers will turn negative in the US, the UK and the eurozone in coming months. But this will be driven by collapsing food and energy prices - the reverse of the surge in commodity prices that led to very high headline inflation numbers as recently as the summer of 2008.

Furthermore, central banks and governments around the world are being far more aggressive in terms of policy than was the case in the periods when deflation did emerge. Interest rates have fallen rapidly and have approached zero in the US and Japan. Central banks have also expanded their balance sheets in recent months with an apparent determination that is reassuring.

Faced with these dangers, where do we find the opportunity? There are several conditions that tend to be met before recoveries from deep bear markets start to emerge.

First, valuations need to reflect the severity of the prospective downturn. This condition broadly seems to have been met in many markets. We estimate that the European markets, for example, are “pricing” a fall of 20 per cent to 25 per cent in earnings per share this year. Price/earnings ratios have fallen to about 8.5 in Europe, assuming that profits fall back to their long-term trend rate of growth. Dividend yields are very high. At close to 6 per cent for the UK and European markets, this is much higher than the available yield on government bonds. Dividends, of course, will be cut, particularly for banks but, all else being equal, if all banks cut their dividends to zero, the dividend yield of the index would fall towards 4 per cent.

While attractive valuations may be a necessary condition for a recovery in the market, they alone are not sufficient. Markets can stay cheap for a long time before they recover, just as they are often expensive for a long time before they fall.

A second condition is that economic activity stops deteriorating at such a rapid pace. Of course, equity markets tend to anticipate economic and profit recovery but this tends to happen when the rate of deterioration starts to stabilise. This may well happen in the next quarter or two.

Third, equity markets need to be able to absorb disappointing corporate and macro news without falling. This is a sign that really bad news is indeed all in the price. How the market reacts to likely weak earnings releases for the fourth quarter and further weak economic data will be an important test.

Fourth, and perhaps most important, is the way that equities are valued against other assets with a less risky profile. This is particularly important in the context of the current bear market because assets, such as corporate bonds, whose claim comes before common equity in the event of a company failing, are looking even cheaper than equities on many measures. For the equity market to recover on a sustainable basis, therefore, it seems that an important pre-condition is that these other markets recover, too.

Until these pre-conditions are met, we expect volatility to remain high with a risk that asset prices fall further, perhaps below their recent lows, as investors face the reality of continued weak economic and company data points, negative headline inflation and increased capital raisings in the near future. But when these conditions are met, possibly by the second quarter or the middle of the year, a very sharp recovery in equity prices is likely.

In historical examples, recovery of stock prices over the year from their lows tends to correlate more with the size of their decline during the bear market than with the pace of the recovery in profits that follow. Rises of 30 to 50 per cent over the first six to 12 months of a recovery are quite normal. So even without a strong economic or profit recovery, a sharp rebound in equity prices is likely when the conditions to boost risk appetite emerge. With interest rates low, and valuations of equities and corporate debt at such extremes, long-term investors should be ready to exploit any near-term weakness.

The author is European strategist for Goldman Sachs

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