Brace yourselves for a looming recession, warns analyst

• Some valuations are at levels not seen since the early 1980s
• But the market turmoil raises the risk of recession...
• ...which means that analysts probably need to cut forecasts further and that sentiment will stay fragile for a while

Markets have gone into freefall in the past week or so. The global index is down by 16% since August 1 and by 19% since it peaked in late April. That is not quite in the official bear market territory yet - but note that some European markets (particularly Germany down 25% and Italy down 24% this month) are.

What should investors do now? Given the damage to sentiment in the past few weeks, it is hard to see markets rebounding healthily straight away. The risk that the market turmoil tips the world into a new recession and causes earnings to turn down sharply has risen. It will be a few months before the smoke clears and it becomes plain how much damage has been done.

Analysts have barely adjusted their earnings forecasts yet but historically, in a recession, they tend to cut them by around 30-40%. However, valuations have become very cheap with the PB (never mind prospective PE) for Europe, for example, down to 1.1x, a level it hasn't seen since the early 1980s.

We still look for three conditions before calling for a bounce: (1) cyclical indicators, including earnings, to come down further, (2) risk events (notably European debt) to pass, and (3) capitulation. We are close to getting there with (3) but not yet for (1) and (2).

In the meantime, we advise investors to buy stocks with good long-term growth prospects, relatively little short-term earnings risks that have become cheap (see our two notes Stocks to buy in uncertain times for Europe and Asia, published this week). We remain overweight the US (more defensive than Europe) and EM (growth prospects still good).