The Dow Jones Industrial Average has recouped more than 50 percent of the losses from the October 2007 peak and the March 2009 bottom.

It’s been a remarkable rally, and the cheerleaders of the world’s major economies say it indicates a return of confidence to markets.

They say the world’s market rallies are based on galloping improvements in economic fundamentals, and this just eight months after many of them were predicting the end of the world as we know it.

It won’t have escaped history watchers, and perhaps a few others who need to get out more, that thus far, the rally looks and feels remarkably similar to the bear market rally after the 1929 Wall Street Crash.

It has been a low-volume rally, and a lot of cash is sitting on the sidelines.

Those holding the cash are either looking on enviously, waiting for a big correction in order to buy at lower prices, or they say they will remain in cash, reasoning that the fundamentals underlying the run up are far from solid.

True, corporate earnings are improving, but looking carefully, it is clear most of the improvements have been

achieved via cost cutting, mainly in the form of reducing staff numbers.

Unemployment is up sharply in most major economies, and many of those in work are working fewer hours and taking home less pay. Few, if any workers have even had a sniff of overtime in the past year.

In the U.S, personal saving has risen to 3 percent, and some commentators suggest it could reach 8 to 12 percent within two years as savers try to rebuild an asset base battered by the slump in housing and securities prices.

So in spite of the massive profits at JP Morgan and Goldman Sachs -- none of which, incidentally, came from

lending to businesses or consumers -- many are unconvinced that corporate profitability is on the road to recovery.

Moreover one or two problems still have to work their way through the economy, and through banks balance sheets. Commercial mortgages. Adjustable rate mortgages that are yet to reset. Credit card defaults.

Savvy investors are still trying to get some of the upside from equities, which still appear to be on a tear. They are however positioned cautiously, and ready to turn around their portfolios and flee to cash and gold (and perhaps large supplies of tinned food and a few automatic weapons) at the first sign of trouble.

Because if history is anything to go by, the lows of March were only the first act in this recession.

Five things to think about this week:

HOLDING UP — FOR NOW 
- A good run in equities has so far been helped rather than hindered by U.S. company results. Some are questioning how long the upward momentum can be sustained given cost-cutting rather than improved revenue streams flattered profit margins. The European earnings season, which cranks up a gear this week, and the release of U.S. Q2 GDP data could be potential triggers for a pullback, but the sensitivity to bad news may depend on how much money is chasing the latest push higher. 
    

EARNINGS 
- European earnings flooding out in the coming weeks may paint a less rosy picture of the banking sector than seen on the other side of the Atlantic. While investment and trading activities should be supportive, bad loan provisions will be particularly closely scrutinised, as will the central and eastern Europe exposure of the likes of Erste. The supply/demand outlook for key commodities plans will also be in the limelight given the battery of oil and chemical firms reporting in Europe and the U.S. 

CORRELATIONS 
- There are signs of some breakdown in the lockstep moves that financial markets had become accustomed to seeing in FX/stocks or stocks/bonds. Calyon research shows correlation between the bank’s proprietary risk aversion barometer and exchange rates has been less robust in the past month. While this correlation nevertheless remains stronger than that between FX and interest rate differentials, the markets’ thoughts are turning to new linkages that might prove better trading guides. 

RESISTING CARRY TRADES 
- The interest in carry trades has grown as investors have become more willing to venture out of the most liquid markets in the quest for returns but the subsequent appreciation in currencies such as the Australian and New Zealand dollar is provoking a push back from the central banks concerned. This suggests that others could be, or have been, tempted by tactics deployed by the Swiss National Bank, whose latest reserves data shows how actively it has sought to keep the Swiss franc in check. Australian reserve data suggest the Reserve Bank of Australia is already taking a leaf out of the SNB’s books, which will keep the market on toes in the coming weeks, while the Reserve Bank of New Zealand meeting this week will offer another chance for central bank rhetoric to counter the prevailing market trend. 

U.S-CHINA TALKS 
- FX reserves, U.S. and Chinese foreign exchange policy, who should do what to correct global imbalances, and trade issues will be on traders’ minds as the U.S.-China Strategic and Economic Dialogue kicks off early in the week. Chinese officials will be keen to avoid sending any signals that would jeopardise the value of the U.S. holdings in their $2 trillion-plus reserves but markets are alert for clues on how Beijing plans to play its medium-term drive for a multi-polar reserve universe.

Five things to think about this week: 

RESULTS RUSH 
- The early wave of Q2 earnings last week prevented any major risk shakeout but there are plenty more results this week, including from banking, technology (Apple, Microsoft), and other sectors (Lockheed Martin, Coke, McDonalds). Investors with bullish inclinations will be looking for the VIX to stay subdued after it fell last week to lows last seen in September 2008, especially if more pent up cash is to be released from money market funds. Bears will be thinking that what might be the S&P’s best weekly performance since mid-March could be setting the market up to be more sensitive to bad news.

BANKS - IS THE BEST PAST? 
-  It is hard to see how bank results this week can top the boost which Goldman and JPM gave stocks last week. More of a mixed bag is likely with the U.S. slate including Bank of New York Mellon, Morgan Stanley, Wells Fargo, Capital One, and American Express while Credit Suisse will be the first major European bank to report. Defaults and delinquencies will be in focus for banks more exposed to the retail sector — both for what it means for their outlook and for what it bodes for household solvency and spending. 

DRILLING DOWN 
-  The breakdown of company results this week (ABB, Texas Instruments, Caterpillar, DuPont, Boeing, 3M) will show the extent to which the inventory rebuilding story, which has helped lift world equities almost 40 percent from their March lows, can offer more sustainable support to stocks in the weeks and months ahead. Earnings this week will be closely scanned to see how inventories are stacking up verus orders. How deeply firms are cutting into costs to defend profit margins, as well as their business investment plans, will be key for unemployment and other macroeconomic data.

FLASH IN THE PAN? 
- Flash PMIs will show whether the positive surprise of the German orders and output data was a flash in the pan for the euro zone, and whether Chinese growth is generating orders in key euro zone countries. British Q2 GDP — the first out of any G7 country — will show the relative strengths and weaknesses of domestic demand, exports and inventory components and it will be particularly interesting in the UK’s case to see just how supportive sterling’s past slide has proved for net trade. 

QE STEER 
-  Minutes from the Bank of England’s last policy meeting and congressional testimony from Federal Reserve Chairman Ben Bernanke should give a clearer steer on where quantitative easing programmes are heading. Key questions investors want answered are why the BoE deferred making a firm decision on whether to extend QE beyond August, and whether the Fed will increase its bond purchases. Government bond markets will be particularly sensitive and signs that central bank appetite for buying government debt is cooling — perhaps because of concern over long-term inflation — could trigger heavy selling, particularly in an climate of strong U.S. bank earnings and rebounding equities.

On some level, every quarter is a make-or-break earnings season, and maybe that’s particularly true for the midsummer earnings season, as it comes at an otherwise quiet time for the broader markets.

But as investors get ready for Alcoa’s ‘kick-off’ of earnings season (and really, Alcoa serves as a nice beginning more for its symbol’s position in the alphabet than as any barometer for earnings), there may be something to all of the fretting this time around. After all, investors endured an awful fourth quarter, where the entire S&P collectively managed to lose money on an operating basis (thanks, AIG, and Citigroup, and GM, and, um…), and a first quarter mostly notable for a slightly better performance than expected - even though earnings were down 36% from the previous year.

It’s still hard to see where the improvement is going to be, however. Earnings are expected to fall about 36% once again, and investors in recent weeks have finally cottoned to the idea that vaulting over low bars really isn’t much to get optimistic about. If the market is truly going to turn higher, it will depend on the quality of earnings, and there, some aren’t so optimistic. Mike Lewitt, president of Harch Capital Management, said, “I don’t think there’s a lot of revenue growth, just shrinkage - basically everybody is shrinking across the board and that’s what we’re seeing.”

The hope, somehow, is that consumer demand is starting to rebound, however slightly, as people get used to the new economic reality - relieved to still have a job, and ready to buy goods after putting off purchases for some time. “Many people made decisions to postpone purchases but not forego them,” said Diane Garnick, investment strategist at Invesco.

We’ll see. What may be necessary is a bit of reading between the lines when listening to conference calls. Visibility is still limited, and executives aren’t going to be eager to put forth rosy expectations when the economy remains stretched. An outbreak of brutal honesty among top execs isn’t likely, but a bit of hesitancy in describing current business decisions would say a lot.

Five things to think about this week:

VOLATILITY
- World stocks’ near-50 percent gain since early March may be levelling off — investors have factored in much of the output recovery that is in the pipeline and fresh impetus could be needed from further improvements in economic indicators or the corporate outlook. With many fund managers yet to wade in with the cash piles on which they have been sitting, a bout of volatility looks more likely than a dramatic pullback.

GROUP OF 8
- Talk of green shoots of economic recovery has removed some of the threat of global economic meltdown and therefore reduced the pressure to come up with coordinated international policy response. The Lecce finance ministers’ meeting will test G8 nations’ commitment to putting up extra money for the IMF and an SDR allocation increase. The risk is that cracks appear on these and other issues (eg QE, fiscal stimulus, etc). Given expanded IMF resourcing was one of the planks on which the equity market/emerging market rebound was built, any signs of pullback could fuel volatility and throw up risks for the assets which have benefited most from that rally.

DOLLAR STANCE
- Asian reserve managers’ reassurance on Treasuries holdings came in the same week as rumblings of discomfort from some emerging market countries (eg South Africa, Israel) on the dollar’s slide and its fallout. Soothing noises from Asia about their dollar-denominated holdings and its FX impact risk being cancelled out by the chatter about international reserve currencies building in the run-up to the first BRIC summit later in June.

BALTICS AND THE FALLOUT
- How much international help Latvia gets to fend off devaluation pressures will determine fate of assets well beyond its own borders. CEEU assets as well as Nordics are affected by fallout and the ripple effects have been seen in euro zone countries with biggest exposure to Baltics and its banking sector.

DEBT ABSORPTION
- Strong demand for long-dated German and UK debt helped reverse part of the recent yield curve steepening. Fed, ECB and market watchers are having a hard time disentangling how much of that steepening was down to economic activity pick up expectations and how much should be attributed to issuance, longer-term price pressure concerns. The market’s appetite to absorb more long-dated paper (from U.S. and Japan this week) will shed more light on how soon central banks might have to fret about longer-term borrowing costs backing up.

(Reuters photo: Lucy Nicholson)

Just how much have world stocks suffered in the past year or so? Try this. According to the World Federation of Exchanges, the market capitalisation of global stock markets has halved. It was $63 trillion in October 2007. At the end of January this year it was only $31 trillion.

It has all been more furious than most people can recall as well. When the internet-stock bubble burst at the beginning of this decade, MSCI’s all-country world stock index lost around 51 percent of its value from peak to trough. In the latest drop, the index fell 58 percent from an all-time high in November 2007 to a new cycle low yesterday.

And it has been fast. The internet-stock bubble decline took slightly more than 30 months. The current fall has taken only 16 months.

As financial markets wrap up the final full trading week of 2008, investors are contending with “quadruple witchings”, that is the day on which stock index futures, stock index options, stock options and single stock futures all expire.

French investment bank Calyon says that in addition the U.S. Treasury debt future also expires on Friday. “More witches than a Hallowe’en party,” the bank said in a note to clients.

“It is Friday, six days before Christmas in the middle of a credit crunch and this will only amplify the movements.”

However, investors, who must have had a fair dose of crises already this year, must be hoping the witching Friday will pass in peace.

As U.S. politician Henry Kissinger once said: “There cannot be a crisis next week. My schedule is already full.”

Financial markets might be in distress and stocks are falling through the floor, but according to James Montier, global strategist at Societe Generale, we are not in the final stage of bubble burst yet. For one thing, the Financial Times is still too big.

At a fund managers conference in London today, Montier — a renowned bear — noted a thesis by economists Hyman Minsky and Charles Kindleberger that bubbles go through five stages — displacement, credit creation, euphoria, critical stage/financial distress and revulsion.

Currently, he says, financial markets are going through the critical/distress stage but we are not in revulsion yet.

“In revulsion, the Financial Times will be three pages long and we will all be ashamed to be working in finance. Stocks will be unambiguously cheap,” he told a group of financial professionals.

Stock markets have fallen so far that they now offer brave, long-term investors a ‘once in a generation’ opportunity, according to LV Asset Management’s Tom Caddick.

While there is little sign of the bad news letting up, stock markets tend to look forward, rather than backwards, and will anticipate a recovery before it happens.

He’s backing up his brave talk by investing his own money in his funds.

However, he warns that while it could feel great in the long-term, don’t expect markets to rise immediately.

You can watch a video of Tom’s views here: