Shares plummets 3% as Wall Street tumbles – is the rally over?

The Australian sharemarket has crashed more than 3% this morning after another ugly night on Wall Street and European markets.

The benchmark S&P/ASX200 index fell 3.4% or 143 points this morning to be at 4013.1 points at 11:30am AEST.

The mood was set after a tough night in the US, where the Dow Jones Industrial Average sank 5.7% as big US companies continued to release poor third-quarter profit results.

So is the short-lived rally of this week officially over? Or are investors just pausing for a bit of profit taking?

Let’s explore the answers with a quick SmartCompany Q&A.

I’ve heard plenty of commentators saying that we hit the bottom last week, but now shares are tanking again. What’s going on?

The week started with a renewed sense of optimism, as even Warren Buffett came out last weekend and declared equities were cheap and he was buying back in. The Australian market enjoyed a positive start to the week, rising 4% on both Monday and Tuesday.

The optimists were even prepared to write off yesterday’s fall of 3.4% as a bit of profit taking after these good gains.

But last night’s falls on Wall Street underlined that this crisis is far from over. While the financial system may have been saved from collapse, the global economy is tanking quickly.

OK, the global economy is tanking quickly, but Australia’s economy is expected to keep growing. So why are local stocks being hit?

Resources companies such as BHP Billiton and Rio Tinto make up a huge portion of the local market and the share prices of these companies are falling in response to big falls in the prices of commodities such as iron ore, coal and nickel.

Why are commodity prices tanking then?

Commodity traders bet that the slowing economy will mean demand for minerals will fall sharply. While it’s obvious the US and Europe are headed for recession, many Australian mining companies were hoping the underlying strength of the Chinese economy could help pull them through the downturn.

But there are growing doubts about Chinese economic growth. Last week Rio Tinto warned growth would inevitably slow. This morning, Deutsche Bank forecast Chinese growth would slip from around 10% this year to 8% in 2009, falling to 7% in 2010.

This means we could be facing a much longer and more serious downturn and that’s why investors are fleeing mining stocks.

For example, BHP Billiton is down 9.2% this morning and has now sunk around 32% in the last month.

It looks like resources companies are going to be under pressure for some time and the rally looks to be over. But have we hit the bottom yet?

That’s one of those questions that you can only answer in hindsight. But it’s safe to say that investors should brace for a lot more volatility over the next few weeks and months. Until more data about the outlook for the global economy – and particularly the Chinese economy – becomes available, resources stocks will be under pressure and the Australian market is going to struggle.

The rollercoaster still has some way to run.