Are we heading for a Bottom War?

Financial markets have plunged over the past few weeks with the UK giving up five years of bull market gains and the US markets more than four years of rising prices.

Everybody wants to know what will mark the bottom of the current market downturn. And after three years of falling stock prices, many investors have been tricked into calling the market's bottom too soon.

However, some commentators have an answer. In his book 'Beat the Millennium Crash' - that was published in 1999 when markets were booming - author Jake Bernstein refers to the phenomenon of a 'Bottom War' as generally marking the low point in financial markets.

Examples of bottom wars are the Spanish-American War, World War II and the Gulf War. For those that do not remember, the Gulf War of 1991 brought to an end the bear market in US stocks that started on Black Monday in October 1987.

Could this phenomenon be repeated if the US decides to attack Iraq this autumn or early next year, opening the Gulf War II? It is still a close call.

Last September Mr. Bernstein suggested in reply to an email from AMEInfo that the events of September 11th might be counted as a 'Bottom War', but that has not proved to be the case. However, in so far as the events of September 11th marked a turning point that has led to the wider war on terrorism and nations that sponsor terrorism, he might be judged correct.

There are still a lot of 'ifs' and 'buts'. If the US attacks, if Saddam Hussein falls from power quickly, but what happens if things go wrong? Stock markets hate uncertainty and this kind of confusion will be quickly factored into prices.

But given that major movements in stock prices are usually preceded by major political events, and wars are about the biggest political event you can get, then the 'Bottom War' theory holds good - at least once the war is successfully concluded.

Certainly Middle East investors - however much they deplore the suffering that wars inflict on innocent people - should watch financial markets closely in the event of a US attack on Iraq. But until then global equity markets may have a very rough time ahead of them, as valuations are still too high for this stage in the cycle. It will be a volatile ride.

Yet markets just follow human nature, and the eventual over-reaction to distress will lead to buying opportunities. At present worries about deflation are compounding a reaction to the insider trading scandals of the previous boom.

But stand up the historian who can name a war that has not been inflationary. That is one reason why wars help to put a floor under share prices which will pick up with asset price inflation. Hence the 'Bottom War' marks the end of share price declines.

Presently price to earnings ratios are back to their long term average in Europe, but investors should wait until they are below average. The point of market over-reaction to bad news is the best time to buy, but few people ever do it. That could just be after a 'Bottom War'.