This is now one of the worst bear markets in history. In early trading on Friday, the Dow Jones Industrial Average had fallen 31 per cent from its January 2000 peak, one of the worst 10 declines the US market has experienced since the first world war.

And the Dow has held up relatively well in global terms. In Germany, the DAX index has more than halved since the peak in March 2000; in London, the FTSE 100 has fallen 36 per cent since its peak in December 1999.

What has made the bear market all the more pernicious is its length. The Dow peaked in January 2000 and many other bourses reached their highs in March of that year. Markets have been falling, with the occasional rally, for 18-20 months. In contrast, it took only two months in 1987 for the Dow to fall from peak to trough.

If one combines time and severity, only four other US bear markets since 1914 are more significant*: 1919-21, when the Dow fell 47 per cent over 21 months in postwar economic disruption; 1929-32, when the Dow fell 89 per cent at the start of the Great Depression; 1939-42, when the Dow fell 40 per cent in the early stages of the second world war; and 1973-74, when the Dow fell 45 per cent in the face of Watergate and the oil price surge.

All those declines were linked to severe economic or political disruption. Does the scale and length of the current decline indicate that investors are expecting something similar?

Clearly, investors are extremely nervous about the prospects for the world economy. The terrorist attacks of September 11 came at a time when the US economy was already barely growing, and many economists are now forecasting a recession. With the Japanese economy already in the doldrums and European economies slowing, the immediate outlook for global output looks bleak.

But central banks worldwide had already cut interest rates before the attacks and have engaged in a further round of reductions this week. Add US tax cuts and a boost to government spending from defence and reconstruction, and stock markets might be expected to "look through" declines in output and earnings to recovery.

Not this time. The September 11 attacks changed everything. First, they were a direct assault on the heart of the US financial system, with immense human and physical costs. Second, they introduced a new level of uncertainty. If the world had avoided recession before the attacks, it was largely thanks to the buoyancy of consumer expenditure; now, consumer confidence seems likely to deteriorate.

The nearest parallel may be the Gulf war, when the US consumer confidence index fell from 101.7 to 55.1 within six months. But that event took place far from the shores of the US; the US mainland has not seen enemy action on a such scale since 1812.

There have been significant effects on certain sectors in the short term: Oliver North, speaking on CNN on Friday, said he was the only passenger on a scheduled flight to New York. But the longer-term effects on confidence will probably depend on the extent of US military action and the prospect of further terrorist attacks. It is virtually impossible for investors to assess such factors. When uncertain, they tend to avoid risk. Talk of a "long war" from President George W. Bush or a jihad from the Taliban only adds to their nervousness. Cash becomes the safest asset.

Lower interest rates, in these circumstances, may not help. Who cares if the return on cash falls from 3.5 to 3 per cent? At least by holding cash investors are guaranteed the preservation of their capital.

The past few days were a striking example of how prices are set at the margin. Few people wanted to hold stocks ahead of the start of a war. Many wanted to sell.

It may be that the current market decline is a symptom of "irrational pessimism" - the mirror image of the "irrational exuber ance" that prevailed in the late 1990s. Some analysts point out that markets quickly rebounded when the US and its allies began military action in the Gulf war.

The problem is that the valuation case is less clear cut than at the bottom of previous bear markets. At the end of 1974, the Dow traded on a price-earnings ratio of 6.2 and a dividend yield of 10.5 per cent; at Thursday's close, the Dow was on a p/e of 22 and a dividend yield of slightly more than 2 per cent.

These still-high valuations (in historical terms) reflect the excesses of the late 1990s bull market, when it was quite common to argue that such measures were irrelevant. The dividend yield on the FTSE 100 index, for example, moved above the 3 per cent level this week; but this level was seen as a floor for dividend yields until recent years.

The bullish case is that equities now look cheap relative to government bonds. According to Mike Lenhoff, chief strategist at Gerrard, the investment group, the UK gilt/equity earnings yield is now at a 20-year low.

But the bond yield/earnings yield has dubious theoretical foundations; it compares equities, a real asset whose value will tend to rise with inflation, with bonds, a nominal asset whose value is fixed, regardless of the inflationary level. In any case, all this ratio may be telling us is that the equity risk premium has risen. In other words, investors are demanding higher returns (and are thus willing to pay lower valuations) to reflect the increased risks of holding equities relative to bonds.

There seems, on the face of it, good reason for the risk premium to have risen in the face of the recent attacks. The "peace dividend", the reduced level of political risk and defence spending that has prevailed since the end of the cold war, may have disappeared. Valuation measures did not provide much of a barrier to the market on the way up in the late 1990s; they may provide little protection on the way down.

A market rally will require confidence on the part of investors that the economic and military consequences of the recent attacks can be contained. But confidence must have been severely damaged by the share price declines of the past two years. US retail investors have been encouraged to "buy on the dips" over the long bear market; over 2000-01, that has proved a strategy for throwing good money after bad.

European retail investors had just begun to be enticed into the equity markets during the past few years. European governments had been encouraging the growth of "popular capitalism" as a means of dealing with the long-term fiscal problem of meeting the pension needs of an ageing population. Given the losses many must have suffered, there must be a danger that share ownership is now distinctly "unpopular capitalism". At the very least, investors will be slow to return to equities again.

Another factor that may be a problem is the existence of "forced sellers". Some, such as day traders or hedge funds, may have bought stocks with borrowed money or on margin. Bass family members said on Thursday they had sold $2bn worth of Disney stocks, partly to repay margin loans.

Other rumoured forced sellers are insurance companies, which may be switching from equities to bonds in order to shore up their solvency ratios. The only confirmed case so far has been Amlin, a Lloyd's of London group, which sold all its equities and switched to bonds last week.

But previous bear markets have tended to throw up cases of financial institutions brought to their knees by the scale of the market's decline. The potential for financial distress is yet another unknown.

Bear markets do eventually end and are, on average, a lot shorter than bull runs. When the markets turn, a few brave souls will make a lot of money. But courage in investment circles is currently in short supply.

* Data taken from Survive and Profit in Ferocious Markets by John Rothchild, published by John Wiley & Sons

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