Fear grips investors as FTSE hits 34-month low

The FTSE 100 crashed to its lowest level since the 1998 Russian debt crisis yesterday, as investors appeared gloomier than ever over the prospect of a recovery in corporate profits.

The FTSE 100 crashed to its lowest level since the 1998 Russian debt crisis yesterday, as investors appeared gloomier than ever over the prospect of a recovery in corporate profits.

A wave of selling sent the index of the UK's biggest companies down 111.7 points to 5,204.3. Investors were spooked by data that showed UK manufacturing heading deeper into recession and, later in the day, that the US services sector is contracting faster than expected.

The market's reaction to scraps of economic news has become increasingly exaggerated. Strategists at the City's biggest investment banks have been searching for clues on how long the global economic slowdown will continue.

The stock market is expected to bottom out a few months before the trough in the economic cycle. That is the way of recessions. Most strategists think the bottom is near; none are sticking their necks out on the question of when.

Khuram Chaudhry, of Merrill Lynch, said the number one issue is whether the sharp contraction in industry is going to lead to a collapse in consumer spending. Pessimists fear the growing number of layoffs across the manufacturing and technology sectors will put the brakes on consumer spending and plunge the world into a deep recession.

"We need confirmation of where the US consumer is going," he said. "Are they going to throw in the towel, or are they going to save the world?"

Yesterday's US data was read as meaning that the service industries are gearing up for a sharp contraction in consumer activity.

Sectors sensitive to consumer confidence are among only a handful to have increased in value this year, with housebuilders and high street retailers close to the top of the league. Suddenly they look vulnerable, too.

Market watchers are braced for a tough few weeks as US companies give their latest guidance on earnings. It seems likely that the "third quarter recovery" predicted earlier this year has not materialised.

The markets have lost faith in predictions, anyway. The highly paid research analysts employed to predict companies' performances have repeatedly been forced to downgrade their expectations this year – and hardly anyone thinks they have gone far enough in trimming next year's numbers.

That dooms companies to disappoint the market, Mr Chaudhry said.

"Forecasts for corporate earnings next year are still way too high. Until they come down, we are going to see profit warning after profit warning."

The collapse in the share prices of the telecoms operators – burdened with debt and unrealistic growth expectations – and their suppliers, like the stricken Marconi, has robbed the market of their heavyweight leadership.

Fund managers first switched into traditionally defensive sectors, such as utilities, pharmaceuticals, tobacco or food, whose products will be needed whatever the economic weather. But these stocks are looking expensive and have tracked sideways since the start of the year.

So what can lead the market out of its bear phase? Might there be a rebound in the technology sector, where share prices are typically 90 per cent off their peak? No, says Mike Young, director of European strategy at Goldman Sachs. The over-capacity in industries serving the New Economy has not been fully worked through, he said. Yet he is predicting the market could be up to 20 per cent higher by the end of the year.

"One of the things that investors often ask is: how can we get a market rally without technology?" he said. "But technology is less than 4.5 per cent of the market's capitalisation these days. Technology hardware, such as semiconductors and telecoms equipment, is an even smaller part."

Mr Young reckons the best hope for a market surge lies in the telecoms operators. The likes of Vodafone, down to 137.5p from a peak of £4, and BT are rebuilding their balance sheets after last year's splurge on third generation mobile phone licences and other expansion.

Telecoms used to be the dominant sector, now it is smaller than both pharmaceuticals and oil companies, at 10 per cent. Biggest of all is the banking sector, which accounts for 18 per cent of the UK market. A market rally looks unlikely if banking shares crumble further and the bulls and bears are fighting over the issue.

In the red corner, Morgan Stanley's Richard Davidson argued yesterday that banks fall in line with economic growth. "As economies slow, lending volumes decline, non-performing loans tend to rise, capital market earnings weaken and costs pick up," he wrote in his latest note to clients.

In the blue corner, many banking sector analysts argue that the lenders have tightened up their risk management systems since the last recession, and have much less risky debt on their books.

The banks have used new tricks, such as selling on the debt, particular in the telecoms sector, in the form of corporate bonds. It is the buyer of the bonds who now shoulders the risk of defaults. Bank shares will be among the first to take off as soon as there are signs of a pick-up in corporate activity, they argue. In the interim, the shares pay a good dividend, so risk-wary investors at least get the guarantee of a good income.

Barton Biggs, Morgan Stanley's global strategist, cautioned: "My strong intuition is that a huge 20-year bull market with spectacular excesses that created stupendous paper fortunes out of thin air cannot be corrected by a one-year bear market that eliminates a few maniacs, after which the game in all its gory glory resumes again."