Shares look set for a mighty fall

After the worst week for shares this year, with Friday the worst day on record so far too, this is not a bad point to reflect on the market outlook for shares in the US markets.

This is also highly relevant to other capital markets around the world. For if Wall Street sneezes everyone else will get a cold, and even the sky-high, oil-fuelled Middle East bourses will not be immune; this could be just the thing to bring them crashing to earth.

Now US share valuations have actually been remarkably resilient in 2005. Ignoring warnings on consumer demand, plunging car sales, the phenomenal trade deficit despite a very weak dollar, and rising interest rates, stocks have held their ground. Investors have been convinced by the rhetoric of Wall Street and kept their nerve.

However, as somebody once noted market forces are like pulling a brick at the end of a piece of elastic; you pull and pull, and nothing happens; then the brick flies forward and hits you in the face.

Perhaps this is where capital markets stand today. Stock valuations are far too high for this stage in the economic cycle - which is on the way down and not up - and will undergo a sharp correction. That downward movement is always a risky one, as stocks tend to overshoot at the up and overcorrect on the way down.

Not surprisingly the bond market has just recorded some improvement. Bonds are a safe haven, and an equity sell-off will also put a cap on interest rates for some time, making a better case for buying bonds. Precious metals are also a safe haven, and silver is already up although gold is showing little improvement.

However, a big sell-off should lead to a flight to bonds and precious metals, and a slump in industrial commodities. After all, in a recession for business there will be less need for commodities, whether that is oil or aluminum.

Real estate might rally a little further after a stock market crisis - that is the typical shift in fund allocation by individual investors. But given the stretched nature of realty values, particularly in the US and UK, this could be very short-lived.

In the Middle East, investors will have to reckon on a lower than expected oil price outlook for 2005 and 2006 and this might well encourage a retreat from present stock market positions. If these positions were not so overbought then there would be nothing to worry about. But sadly this is not the case - and there will be some investors who land themselves in terrible trouble.