One of our favorite maxims is 'markets are slow to overreact', and stocks seemed to be overreacting last week. The S&P 500 was only 1.5% off its 2011 high of 1364 just two weeks ago, despite Japan's earthquake, tsunami, and nuclear meltdown in March, Europe's ongoing financial woes, the debt ceiling/budget deficit imbroglio, sharp downward revisions to GDP, and a struggling jobs market. Strong earnings growth, a cheap US dollar, and an accommodative Federal Reserve were sufficient to keep stocks in a rising trend. Unfortunately after weeks of anticipation of the August 2 debt ceiling 'deadline', stocks sold off once they realised that Washington only managed to kick the debt ceiling and budget problems down the road. As a result, we must acknowledge that recession risks have risen. Economic growth slowing to current levels - ISI Group has called it 'stall speed' - has historically led to recession. However, since a portion of this slowing was due to effects of the earthquake, we still think the odds of recession are well below 50%. Last week's jobs report sand purchasing managers surveys, while not great, suggest the economy is still growing. That said, we are worried that the stock market still has some downside potential since the overreaction phase seemed to just get started last week, hence our risk management tactics.

David Fuller's view Western bank shares had been leading to the downside for weeks, so when the Nasdaq 100 Index (daily & weekly) and S&P 500 (daily & weekly) reaffirmed resistance near range highs on 27th July, it was the equivalent of 'the Emperor has no clothes' moment for technical traders. They began to conclude that Wall Street's large trading ranges were top formations rather than consolidations within the 200-day MAs prior to renewed strength.


What next for stock markets?

There is a risk that the rapid deterioration in stock markets will increase the reluctance of companies to hire people and expand in the west. Bear markets usually have an economic impact.

Fullermoney has often said that most governments are crisis oriented. Europe's political leaders have been forced into action and appear to have no option now but to move swiftly and create the fiscal union which many commentators have long pointed out would be necessary to hold together a single currency. I think they will succeed in doing this.

The US Federal Reserve is under pressure to bolster confidence - quickly, if it is to have any chance of preventing a slide back into recession. I expect QE3 although perhaps by another name. Bond yields are not the problem; it is the stock market slump which has rapidly become a focal point of concern.

Growth economies - led by China, India and Brazil - are in a position to reverse their inflation-fighting monetary policies now that commodity prices are plunging in anticipation of a downturn in the business cycle (The Weekly View also makes this point). Too high prices for crude oil (Brent & WTI) - often cited by Fullermoney as a major contributor to inflationary concerns and ultimately slowdowns in GDP growth, have fallen back sharply.

On a very bleak day for stock markets, the one bit of good news is that we are rapidly heading for a market reset. Lower commodity prices - a precondition for the next phase of global GDP growth in our view - will damp down this source of inflation for the short to medium term. Valuations for many equities are falling back to increasingly attractive levels, not least for Fullermoney themes, even allowing for the earnings downgrades which we anticipate.

Currently, stock markets are quite oversold on a technical basis. However, I would not trust the first bounce which may occur mainly on short covering. There is a risk of a further overshoot to the downside, particularly if policy responses are slow or viewed as insignificant. It takes time to rebuild technical support and confidence among investors who will want to see pro-growth policies from central banks and their respective governments.