With equity markets having lost around 25% since their 2007 high, it is tempting to believe that the worst is over and that current stock prices represent a buying opportunity. Investors should resist that temptation.

Equity markets have recovered slightly since their mid-July low which followed the Merrill Lynch write-down/asset disposal announcement. That recovery was due to the 20% fall in the oil price between 14 July and 18 August. However, from a fundamental point of view, there is no reason to become positive on the outlook for equity markets again and I would even suggest that it is not too late to reduce equity exposure even further.

If one puts the beginning of the credit crisis at July 2007, we are now well into the second year of that crisis and it seems that things are getting worse, not better. Economic data released in recent weeks highlight that the global slowdown is deepening and spreading. The financial crisis continues unabated increasing the risk of a global credit crunch. Write-downs have led to a significant reduction in the capital base of the banking sector, weighing on banks' ability to lend. It is important to remember that financial institutions operate on the basis of leverage. A bank whose assets are 15 times its equity capital will have to reduce its assets by $750 billion if it writes off $50 billion of capital. It could of course raise capital as an alternative to shrinking its assets but firstly raising capital is becoming more and more difficult and expensive, and secondly the pressure on banks to deleverage is intensifying. Credit supply will thus continue to dwindle. Before this crisis began, credit extension in the United States was growing at 4% a year, now the figure is minus 7%.

The risk of a vicious downward spiral is thus increasing, with economic weakness and the financial crisis feeding on each other. The combination of economic slowdown, financial crisis, huge leverage in the financial sector, a massive real-estate bubble in several countries, an over-indebted American consumer with a negative savings rate, already low interest rates and rising food and commodity prices is unprecedented in modern history which is what makes the current situation so dangerous. The situation is further aggravated by the fact that, particularly in the United States, the initiatives taken by the authorities seem to be guided by the circumstances of the moment and political considerations rather than by an assessment of what it would take to put the US economy back on a more sustainable growth path. The recent massive tax rebates aimed at perpetuating the consumption boom are a case in point.

The share of private consumption in the Gross Domestic Product (GDP) of the United States has risen constantly since the mid-1990s reaching a record high of 72% in 2007. Over that time frame, the rise in consumption spending surpassed income growth leading to a drop in the savings rate to 0.4% at the end of 2007. The drop in the savings rate and rising US household debt were not considered problematic as long as the value of households' assets - equities in the second half of the 1990s and real estate in the first half of the current decade - continued to rise. The ratio of debt-to-assets of households didn't seem to be a problem as long as the denominator (assets) and the numerator(debt)continued to increase together. With real estate and stock prices now falling, this ratio is rising rapidly. What's more, the increase in borrowing costs makes the debt more difficult to service. US consumers thus face intense pressure to deleverage at a time when unemployment is rising and when higher food and energy prices are constraining their budgets. This is not a positive outlook for discretionary spending. The 72% of US GDP made up of consumption thus faces very strong headwinds.

Recent data has also put a question mark over the decoupling thesis, the idea that even if the US economy were to weaken, the rest of the world would continue to grow. Economic weakness is certainly no longer limited to the United States or other countries which, like the US, have experienced a real-estate boom (such as the United Kingdom, Spain and Ireland). Second quarter data for the euro zone showed a contraction in GDP. The same is true for Japan. This is hardly a surprise given that the financial crisis is affecting European banks as much as their American counterparts, meaning that the reduction in credit supply and the risk of a credit crunch are global in nature. However, the main idea behind the decoupling thesis was the rise of the emerging countries and here the jury is still out. Growth in the developing world remained strong through the first half of this year. It is now slowing because of the impact of rising food and energy prices and monetary tightening by central banks in a bid to to combat inflationary pressures. Severe economic weakness in the United States and Europe would undoubtedly have a negative impact but if there is one positive point for the global economy, it is the improvement in the economic fundamentals of the emerging economies. As a matter of fact, the challenge for these economies is exactly the opposite of that facing the United States - to shift the mix of growth from exports to private consumption.

We have entered uncharted territory characterised by the possibility of a debt-driven deflationary outcome. As investors, we should therefore act with utmost prudence. As I said in my article dated 20 July (Active investing), we are in a cyclical down phase of a secular range-bound market. Equity markets may not look too expensive based on current earnings but there is the risk of a sharp fall in earnings given the economic environment, especially since operating margins remain near all-time highs. In the 1991 and 2001 recessions, corporate profits of the S&P 500 companies fell 25% and 37% respectively from peak to trough. The peak in this cycle was around $90 on a trailing 12-month basis. Assuming a decline similar to that of the last 2 recessions would mean earnings of between $57 and $67. At the current level of 1290 for the S&P 500 this would give a price/earnings ratio of between 19 and 23, hardly a bargain. What may look reasonable today may look expensive in hindsight.

In times like these, the priority must be to preserve capital even at the risk of missing short-term bounces in the equity markets. This does not mean that one should be completely out of equities, especially as a long-term investor. There usually is a tendency for investors to view equity markets as one homogenous asset class. Instead, one should distinguish between regions, sectors and companies focusing on financial strength, earnings stability and valuation.