While the extreme nature of the sell-off in risk assets over the last two weeks was part of our contingency planning, its magnitude still surprised us. We must now assess what it means and whether it is excessive, or prescient. What is clear is that investors are increasingly convinced a developed-world recession is coming, and we think they are assigning it about a 70% probability. This probability is likely based off high yield spreads, Treasury yields and stock valuations. We currently disagree, and put the chance of recession at less than 50%.

David Fuller's view Rod Smyth and colleagues make a number of interesting points in this issue which I commend to subscribers. These include a review of their Three Rules for Investing.

What about the important point concerning whether or not we see a developed-world recession?

The recession question really matters in my view, as it would mean still weaker GDP growth on a global basis and therefore a sharper drop in corporate profits than analysts are currently forecasting.

Stock market historians, as I have mentioned before, will point out that when US GDP is still growing, S&P 500 Index corrections are mostly confined to a 10 to 15 percent range. Other stock markets, being smaller, will usually have somewhat larger corrections.

However, during recessions the S&P's corrections are more likely to become statistical bear markets in the 25 to 35 percent range, and sometimes more as we last saw in 2008/9. To date, the S&P has fallen just under 20 percent from this year's high on 2nd May.

I would feel more optimistic about the chances of the US avoiding a recession if growth economies were not still maintaining their monetary tightening bias, ensuring that they experience at least growth recessions.

Markets are known for their frequent overreactions, which is another way of saying that investors are prone to over exuberance in bull trends and capitulation in downturns. Nevertheless, to the extent that the stock market is a leading indicator, the message is not encouraging.

This can also become self-fulfilling if it makes everyone feel more cautious. I certainly feel more cautious and I suspect that a number of you do as well. I think this is resulting in more PER compression in line with the secular cycle of valuation contraction in western stock markets. We have been talking about this secular trend, which we last saw between 1967 and 1982, for over a decade and it is not over.

The single most positive development, in my opinion, is that short-term interest rates in the USA and Europe remain historically low. However, this also means that the Fed and ECB were unable to reload their interest rate guns, before the economic downturn which we are currently experiencing.

Psychologically, this makes it doubly important for central banks in growth economies to moderate their tightening bias. They will, but possibly not in time to prevent the US and more European economies from dipping into recession. Meanwhile, growth economies remain concerned about commodity price inflation which is their major problem.

Lastly, while Mr Bernanke remains Fed Chairman we cannot rule out the possibility (probability?) of QE3, perhaps by another name, in which he could get the biggest bang from his fiat buck by purchasing S&P 500 futures. Awareness of this possibility should mitigate downside risk for the US stock market in the months ahead. Moreover, the announcement of another asset buying programme would almost certainly trigger a significant stock market recover, as we saw after QE2 was launched in August 2010.