Following precipitous drops in equity prices around the world in 2008, this year has brought a sigh of relief for stock market investors since March. Global indices have recovered from staggering losses of the previous year, albeit most remain well below their earlier peaks. Notwithstanding the announcements of a budding economic recovery and stock market gains so far, the recent recovery is likely a bear-market rally in an otherwise downward trending market.

In 2008, benchmark stock indices in some 32 of the 84 countries tracked by Bespoke Investment Group, were down more than 50%. The hardest hit was Iceland, whose benchmark index lost nearly all of its value with a decline of close to 95%. Ireland was also one of the worst market performers, with the ISEQ index losing about 66% of its value. Performance by the major global indices was likewise dismal, with Germany’s DAX index plunging 40%, the U.S. S&P500 index falling 39%, and the UK’s FTSE dropping 31% in the year as a whole. Among the largest emerging markets, Russia’s benchmark index lost 72% of its value, China’s index dropped 65%, and Brazil’s BOVESPA fell 41% in 2008 alone.

However, in a sharp contrast to 2008, stabilisation in the international financial markets following the synchronised and enormous fiscal and monetary interventions from the global governments, along with better economic news, has restored confidence in the financial system and the equity markets. As a result, most stock indices worldwide have recovered robustly this year, posting gains of as much as 51% in Brazil, to 13.5% in the U.S. (S&P500), 12.8% in Germany, and 10.5% in the U.K. The Irish ISEQ index is also up 28% from the beginning of the year. In fact, the largest gains so far this year have been in the severely beaten emerging markets, which have posted stellar gains in stock prices.

The restoration of investor confidence and the emerging signs of economic recovery have boosted optimism about stock market performance. Yet, using the U.S. stock market as a proxy, which is often the precursor for the global equity performance, various market indicators indicate an overly bullish investor sentiment, which is unlikely to be sustained. For instance, short interest as a percentage of float on the U.S. indices is currently at its lowest level since February 2007. This may indicate that investors are now too bullish. Investors Intelligence measure of bullish sentiment is also at its highest levels since January 2008 and the bearish sentiment is at its lowest level since late 2007.

Although stock market gains this year have restored optimism among many investors in the prospects for a recovery in the stock markets, a slew of indicators and the fundamental analysis suggest that the market is likely to resume its downward trend. In fact, the recent market rally is primarily a bounce-back from the oversold levels caused by the investor loss of confidence in the stock market and the financial system due to the collapse of the securitization market, the bursting of the credit bubble, the failure of several major investment banks, and the governments’ interventions to rescue the key institutions underpinning the market economy.

Various indicators urge caution about expectations in regard to continued stock market gains. Earnings prospects remain weak. For example, S&P 500 as a whole is expected to see earnings decline by 21.8% in the third quarter. However, at the same time, the price-to-earnings ratio for the index has jumped from 10 to 18, the highest since 2004, as a result of a surge in stock prices against a decline in earnings. The rise in the ratio is primarily a result of the prices rising much faster than earnings and is “justified” on the grounds of positive expectations of future earnings growth. Earnings will, indeed, improve in the coming quarters, but they may not improve enough to validate the exceptionally high ratios and to support a sustainable market growth. Disappointments in expectations of earnings performance will only bring investor confidence down, helping the market resume its correction.

In addition to the current overvaluation of stocks overall, economic indicators in the short term are likely to support the market, but are unlikely to suggest a robust economic recovery. In fact, despite the early recovery in terms of manufacturing output, housing construction, and consumer spending-some of which may be temporary in nature-unemployment in major economies will continue to rise and disinflationary and mild deflationary trends will persist. Just today we see more U.S. jobless data indicating yet another rise. While some may assume that low interest rates, mild inflation (even deflation), and the currently recovering economy all support sustained stock market gains, it is in fact the long-term overcapacity and extensive leverage, constrained credit, and continued financial problems that will keep the earnings prospects limited in the near future. The subpar economic growth worldwide and limited earnings prospects, for an extended period of time, will likely limit the stock markets’ upward potential and will cause it to revert to its previous trend.