At the very bottom of last October's panic-driven selling in global stock markets, Monitor stuck its neck out. Just because markets were in undoubted overshoot territory, with equity valuations plumbing their lowest levels in years, did not necessarily mean that shares offered a great buying opportunity, argued the October 28 column. 'The trickle of corporate defaults and failures of recent weeks could turn into a flood as business conditions worsen, further damaging sentiment and forcing share prices even lower,' it warned. Well, that prediction has proved partly right. Although stock markets around the world initially rebounded once the forced selling abated, investors' high spirits have since been dampened by a constant stream of bad news. Last week, with fears mounting once again over the health of the US financial system, the closely followed Dow Jones Industrial Average slumped below October's trough, even falling below the lows seen in March 2003, in the run-up to the US invasion of Iraq (see the first chart below). Yet if October's warning was partly right, there is no doubt that so far it has proved mostly wrong. The Dow Jones may be plumbing new lows, but as a price-weighted index consisting of just 30 stocks including ailing financial giants Citigroup and Bank of America, it is not the best representative of overall market movements. In contrast, the broader capitalisation-weighted S&P 500 index remains 2 per cent above its October bottom, despite the gloomy outlook. Markets in Hong Kong and the mainland have held up even more strongly. Despite falling last week, Hong Kong's Hang Seng Index is still 15 per cent above October's low (see the second chart), while the H-share index is up 42 per cent. Meanwhile on the mainland, the Shanghai Composite Index is 33 per cent above last year's low point. Some powerful factors have helped support the prices of Hong Kong-listed stocks. Although many ordinary investors have bailed out of equities - retail participation in the Hong Kong stock market has slumped to a record low - professional money managers remain keen. They are obliged to invest their clients' funds somewhere whatever happens, and on that basis Hong Kong has appeared an attractive bet. In the short term, many have put great faith in the ability of the central government to support growth on the mainland with its massive economic stimulus package, and have enthusiastically bought the shares of companies whose earnings are likely to benefit the most. Meanwhile, for those whose belief in China's longer term growth prospects remains undimmed, current valuations represent a compelling buying opportunity. As a result, China and Asia ex-Japan equity funds tracked by specialist research house EPFR Global have attracted cumulative inflows worth more than US$2 billion since the September collapse of Lehman Brothers. Yet the faith of many of those investors could be shaken over the coming months. For one thing, despite a solid stream of downward revisions, expectations for the 2008 earnings season now getting under way could still turn out to be overly optimistic. Last week's announcement by the Bank of East Asia that profits fell 99 per cent last year could be an unpleasant taste of things to come. Although analysts had expected a sharp decline in earnings after BEA wrote down its entire portfolio of collateralised debt obligations, they had failed to forecast the full extent of the deterioration in its more plain vanilla businesses. The risk now is that a stream of poor earnings announcements over the next six weeks could puncture sentiment, causing an outflow of funds. There is also the danger that Asian credit conditions could tighten further as struggling US and European banks reduce their loans to the region and retreat to their home markets. According to Bill Belchere at investment bank Macquarie, developed world banks are likely to reduce their exposure to Asia by between US$500 billion and US$1 trillion, with steep withdrawals continuing into the second quarter of the year. If he's right, and officials including Hong Kong Monetary Authority chief Joseph Yam Chi-kwong are certainly worried, then the business environment for Hong Kong companies will deteriorate significantly over the coming months. Then there is the chance that investors have placed too much hope in China's stimulus measures. Much of the 4 trillion yuan (HK$4.54trillion) package is supposed to be funded by increased bank lending, and on paper the banks are playing their part, extending 1.6 trillion yuan of new loans in January alone. However, there are signs that instead of flowing to the real economy, much of the new lending has either been channelled straight into the money markets, or into the stock market, where it has fuelled the recent sharp rally and heightened the risk of another abrupt sell-off. And finally there is the risk that new losses sustained elsewhere could blunt the risk appetite of the investors who have pumped money into Hong Kong and mainland stocks this year, leading to a new retreat from local markets. As a result, October's warning still stands: stocks might appear attractive at current prices, but they could easily fall further over the coming months.