In previous deflationary episodes in history, such as the 1870s, 1930s and Japan in the 1990s, there are always long periods of rising stock markets within the downtrend.  These were always based on an apparent improvement in fundamentals which ultimately turned out to be a false dawn.  How can we differentiate between the suckers’ rally and the start of a new bull market?

The key is to understand where we have come from and where we are heading.  Mean reversion, or “getting back to normal” in layman’s terms, is one of the most powerful long-term forces in markets.  But what is normal?  At the end of a multi-decade era of prosperity (loosely defined as early 1980s to 2007) punctuated only by two minor recessions, good times feel normal.  As a society, we became used to job security, easy credit, low inflation and rising asset prices with low volatility.  Getting back to normal is, politicians would have us believe, a return to this environment.

But the last few years have not been normal.  We have just been through an unprecedented period of credit expansion with consumers, in this country and others, taking on historic levels of debt.  The future will involve unwinding this process.  Debt is simply future wealth brought forward.  Whether you save then spend, or spend then earn; income and consumption must match over time.

Much energy is being spent on how can we stop this happening again.  But why bother?  Whatever legislation is put in place now will be repealed in 70 years when society again decides “it’s different this time”, just as the US Glass-Steagall Act that split investment and retail banking was repealed in 1999.  In the meantime, the scars of this experience will chasten borrowers and lenders better than any act of government.

Most of current government policy assumes that credit availability is the problem, that people would be happy to have mortgages of five times their salary if only the banks would offer it.  This misses the obvious fact that the psychology of prosperity that underlay our society has been broken.

Whether you are a bank, a company or a homeowner, the primary motivating force driving economic decision-making is now one of deleveraging.  Someone who fears for their job does not overstate their income on a mortgage application in order to borrow more.  Banks who fear declining asset prices do not create off-balance sheet vehicles to circumvent capital adequacy regulations.  We are now in a "Timid New World", one where reckless lending and borrowing will be neither demanded nor supplied.

This reversal in psychology will manifest itself in an unwinding of many of the capital market terms we have seen over the last two decades.  House prices, which have been consistently rising as a multiple of household income, will revert to, and likely go below, their long-run averages.  Savings rates in the Western world, having gone below zero, will turn positive for many years to come.  Emerging markets, which have provided the supply for the Western consumer binge, will have to adjust their economies to rely more heavily on internally-generated growth, not simply ever increasing exports.

We will see subtler effects as well – individually-wrapped washing machine tablets on a 400 per cent markup will be swapped for boxes of powder;  £2 pro-biotic yogurt drinks will seem less essential as part of breakfast.  Chickens will sadly return to the battery farm from their free-range health spa.  Many companies have seen a huge margin boost from the consumer willingness to treat themselves.  We can expect a big mean reversion in returns on equity.

In this Timid New World, certain investment strategies will not be viable.  Liquidity and limited use of leverage will become priorities.  Investors need to not only consider the returns they can get on their capital - they have to consider whether they can get their capital back at all. 

One critical question should be whether the underlying markets always offer liquidity.  Certain asset classes such as commercial property were highly unsuitable for retail funds as they could never offer the liquidity retail investors demand.  It should come as no surprise that most investors want their money back when the market is at its worst.  Many commercial property funds were forced to halt redemptions, utterly unable to raise cash for their investors. 

A basic rule of thumb should be to stick to funds that operate within exchange traded markets such as equities and commodities or highly liquid products such as foreign exchange or government bonds.  Look for managers who have a successful track record in previous downturns (i.e. early 90s, 2001-2003) as well as bull markets.

Similarly, avoid managers who have halted redemptions in any funds unless you have thoroughly understood why they have done so.  Finally, be prepared to get more proactive with your investments.  Buy and hold forever simply will not repeat the returns of the last few decades if we truly are in a deflationary world.  Either find absolute return managers or try to time the market yourself.  In the 1930s, buying equities for three-month holding periods at the points of maximum industrial contraction was a highly profitable strategy.