One of the harder realities to come to terms with in financial markets is that different rules apply at different times in driving performance. It’s critical to get a fix on the ‘regime’ at work to understand the rules of engagement in any period. Otherwise, as the German theologian Dietrich Bonhoeffer put it: “If you board the wrong train, it is no use running along the corridor in the other direction.”

For much of the past year, financial markets have been ‘decoupling’, which means that emerging markets have begun to chart their own course independent of the developed world. All assets linked to the runaway growth of developing countries are on fire, while those tied purely to developed markets are lagging considerably. Emerging-market stocks, which were up 35 per cent as of mid-December, are the main factor behind the nearly 10 per cent overall gain in global stocks.

However, with the odds of a US recession in 2008 rising sharply in recent weeks, pessimists suggest that a shift to a full-fledged global bear market in stocks is underway. They argue that while the world economy has withstood the 2 per cent slowdown in US growth in the past few quarters, a sharper slowdown will lead to a ‘recoupling’ of economic activity between the United States and emerging markets.

Investors now have to make the crucial call as to whether a decoupling or a recoupling regime will prevail in 2008. The rules of engagement under the two regimes would indeed be quite different. If the decoupling scenario extends into the new year, emerging markets could turn out to be the mania of this decade and soar even higher, as investors flock to them in ever greater numbers. On the flip side, if the dictum that “the United States is still all-important” holds true, we are likely to witness a global bear market that spares no asset class.

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