The past few weeks have seen lots of gloom surrounding the investment outlook.
The return of the sub-prime mortgage crisis in the US has led to renewed talk of a credit crunch. There has been talk of a looming "Great Depression" after the Bank for International Settlements annual report referred to parallels between the current situation and the 1920s.
Even the headline "best financial year for Australian shares since 1987" has a somewhat negative undertone because we all know how 1987 ended.
The AMP's chief strategist, Dr Shane Oliver, believes we are now entering a more risky phase in the cyclical bull market in shares, but it has further to go. Recent developments do nothing to change this.
The sub-prime crisis and new debt instruments
Worries about a US credit crunch weighing on investment markets and the US economy have re-emerged in the last few weeks after two US hedge funds experienced large losses on structured credit investments with exposure to sub-prime mortgages (loans to borrowers with poor credit credentials).
In recent years there has been a boom in collateralised debt obligations (CDOs) and collateralised loan obligations (CLOs).
These arise from pools of debt or loans which have been parcelled together and then sold off in tranches representing different levels of credit ratings and risk to hedge funds, pension funds and other investors.
By doing this the risk is spread across multiple investors and hence the amount of capital raised can be greater.
The US housing downturn has seen rising delinquencies and defaults, particularly among sub-prime borrowers.
This has seen a fall in the value of mortgage debt and CDOs which are exposed to it. Many fret that the shake-out in CDOs on the back of the sub-prime crisis will feed through to the broader US credit market and undermine the flow of liquidity into the share market via leveraged buyouts.
So far there is some tentative evidence of a spill over with the gap between speculative grade corporate debt yields and US treasury bond yields rising about 0.2% over the last few weeks and various private equity firms pulling out of buyout deals (such as Coles) as the cost of debt rose.
It's likely that the US housing downturn will get worse before it gets better.
A significant proportion of US subprime mortgages on low initial "teaser" loans are due to reset to higher adjustable rate loans. Lending conditions are tightening thanks to regulatory action and problems in the sub-prime securities markets and this will likely lead to a further fall in home sales and house prices.
This could in turn all lead to further upset in sub-prime securities markets made worse by the uncertainty surrounding the actual exposure of US investors.
More broadly, the housing downturn will help ensure that US economic growth remains sub-par over the rest of the year which should lead to a further reduction in inflation. This in turn will help put a lid on the recent back up in bond yields, if not reverse it.
However, we remain of the view that sub-prime and related problems won't lead to a broader credit crunch:
• The proportion of US mortgages ultimately likely to be affected is small – maybe 2 or 3% – and most US home borrowers are in good shape with strong balance sheets, solid income growth and are on fixed rate loans.
• The positions ($US30bn or so) of the Bear Sterns funds appear to be a fraction of those of LTCM (over $US1 trillion) or Amaranth when it blew up last year.
There is a big difference between problems in the US mortgage market which has been the subject of boom conditions over many years with surging household debt and the corporate debt market in the US where corporate debt is still relatively low.
Balance sheets are in good shape and there has been none of the overinvestment that normally leads to more widespread economic problems.
While the current crisis has resulted in a bit of a spill over into speculative grade debt yields, the 0.2% rise in speculative grade credit spreads is consistent with normal volatility and spreads remain very low.
In fact the main driver of higher corporate borrowing costs over the last few months has been an increase in bond yields which is likely to reverse as it becomes increasingly obvious that US economic growth is not taking off.
• Finally, with US inflation likely to fall there will be plenty of scope for the Fed to head off broader problems by cutting interest rates.
The Great Depression of 2008, 2009, 2010, 2011…
In recent decades there have been numerous warnings of a "Great Depression" ahead. In fact I have books warning of Depressions in 1983, 1990, 1995, the Millennium.
Most are predicated on worries about rising debt levels and investor risk appetite. So while the Bank for International Settlements is right to be concerned about the risks, references to the Great Depression need to be treated with caution.
It's also worth noting that the Great Depression and the Japanese slump of the 1990s were not caused by prior share market falls, but rather the failure of policy makers to recognise the problem until it was too late.
The US earlier this decade clearly learned the lessons of the 1930s and Japan in the 1990s by moving quickly to ease fiscal and monetary policies.
Putting it all in context
Our view for some time has been that we are entering a more risky phase for shares.
Cyclical bull markets normally go through three phases: a recovery phase from excessive pessimism; an earnings driven phase where strong earnings growth drives share prices higher; and an exuberance driven phase where share prices rise faster than earnings – as investors become increasingly exuberant pushing valuations to extremes.
Stage three is often the most ex
