Is there a financial crash in the making?

At present there is a rally in bullishness in the financial markets with considerable optimism that the worst may be behind us in this three-year bear market. Yet there is still good reason to believe that we have not really seen the true financial crash of this cyclical downturn.

Share valuations remain too high. Analysts note that the final phase of a bear market is usually marked by a period of capitulation when everybody gives up on share ownership. We have not seen that yet. In any event, the end of a bear market is never marked by mild euphoria about nothing in particular, which seems to sum up the mood today.

House prices also remain too high. What has gone up must come down. In the UK house prices have been falling for the past four months. Again house prices do not usually spontaneously recover from a downward trend, and given the outrageous overpricing evident in the market this downward trend clearly has some way to go.

This is not a bull factor for any economy. Much more consumer wealth is tied up in housing than shares. And so as 'The Economist' magazine noted recently a house price crash would have a very hard impact on the real economy in many countries.

It is quite reasonable to argue that rising house prices have kept many economies afloat in the face of falling stock prices over the past three years. But what happens if this support is kicked from under the economy?

Moreover, record low interest rates - and the Federal Reserve is believed to be plotting another cut at the time of writing - are a sign that things are pretty bad. They would not be this low if the financial state of the world was good.

Oil and other commodity prices are also stubbornly high, and are effectively a tax on the industrialized world for the oil producing countries. But they do nothing to aid economic recovery. Iraq is in a mess and that is keeping oil prices high.

Thus the bullish mood at the moment is at risk from an imminent reality check. That might come in the form of profit warnings from key companies, a few major bankruptcies or a sudden retreat in property prices, or a combination of these factors.

Hence the classic hedges of gold and commodities should be considered as a safe haven. Oil and gold stocks probably have there best times to come. Why would you buy equities when analysts can see only a limited upside, and the downside is clearly what has been gained since the trough of March? Watch out for October, the traditional month for stock market crashes.