2001 was the second consecutive year of declining equity prices

Firstly, the bottoming of the U.S. economy is in sight. Although the latest payrolls data has mixed implications as the increase in the nonfarm workweek to 34.2 hours from 34.1 hours was offset by a drop-off in private payrolls, that increase was led by the manufacturing sector.

As a leading economic indicator and combined with more overtime, the manufacturing work week suggests that an improvement in production and employment is forthcoming. Also, existing home sales and new home sales have shown a strong rebound, underpinned by aggressive rate cuts from the Federal Reserve. A firm housing market bodes well for other consumer spending. Consumer confidence has shown some renewed vigor, based on improved readings in December's Michigan and Conference board indexes that beat expectations.

On the whole, these reports suggest that the economy is on the road to recovery. Historically, 3 months after the economy bottoms, S&P 500 rose 14.6% on average with standard deviation of 16.6. Six months after bottoming, S&P 500 rose 19.8% on average with standard deviation of 10.9.
Secondly, improvements in market perceptions will lessen the valuation concerns as they create the reasons to invest. Presently, the S&P 500 technology sector P/E ratio based on current earnings is around 50 times, much higher than the S&P ex-technology sector P/E ratio of 21 times. However, as earnings downgrades since September 11 are now stabilizing, the market now expects earnings will improve to make the technology sector P/E less expensive.

Upward revisions picked up significantly in end-2001 as measured by the upward revisions as a percentage of total earnings per share revisions for technology firms. Earnings reductions seem to have bottomed in October as measured by the monthly upward revision percentage versus the average of prior five same calendar months since 1978. Also, the rebound in Philly Fed-6 month outlook for capital expenditure has improved the expected business outlook for the technology sector. Exacerbating the trend of rising expectations were strings of encouraging forecasts from Intel, Advanced Micro Devices, Sun Microsystems and CISC).

Finally, the appallingly unattractive returns from money market funds and cash have perpetuated portfolio rebalancing in favor of equities. The excess liquidity in the market will support a higher P/E level as excess money supply (9-month lag) and the year-on-year change in P/E have a high correlation. Moreover, the Federal Reserve is likely to stick to its previous pattern of not hiking interest rates until after the unemployment rate has peaked.

Europe remains attractive due to a stronger cyclical gearing to global recovery and a more attractive valuation. The European recovery should begin roughly in 1Q 2002. Although the ECB has not cut rates as aggressive as the Fed, it will move to probably cut by another 50 bps. Because Europe is less dependent on technology than the U.S., the technology collapse had a smaller effect there. Similarly, a technology led recovery should be more muted in Europe but European growth should accelerate as 2002 progresses.

In terms of the 10 year bond yield/equity earnings yield, Euro-zone is now at its lowest point since 1997. Therefore, its valuation (0.75) is much more attractive than that (1.50) of the U.S. Coupled with the expected fall in inflation to as much as 1% by the end of 2002, further rate cuts ought to bolster bonds, which should be good for selective insurance stocks that have lagged behind the bank stocks. The jump in insurance premium subsequent to the WTC tragedy as well as a fall in provisioning should ensure a bounce in insurance earnings in 2002.

The global recovery theme ought to benefit the Japanese equities but the market is likely to underperform due to the lack of any structural change in the economy. The TOPIX level of 990 reached on September 12 will prove to be the bottom for the equity market is this cycle. This suggests downside for Japanese equities should be limited to perhaps 5-10% from the current TOPIX level. Although Japan's GDP has now declined for two quarters in a row, October's export volume fell 9.6% y-o-y, the smallest decline in five months.

Also, industrial production in October also fell less in y-o-y terms than in September. Inventories showed another large fall of 1.1% m-o-m, confirming inventories peaked in May. These reports suggest a cyclical recovery should take place around the middle of 2002.

In previous cycles, TOPIX has tended to bottom almost simultaneously with industrial production. However, the rise in the Japanese market in 2002 will probably be constrained by the few signs of structural changes: no solution to the problem of banks' bad debts; only very half-hearted corporate restructuring; and Prime Minister Koizumi still faces an uphill task to implement any of his reform platforms. Interim earnings continued to be hurt by deflation as recurring profits fell by 34%. However, the market appears to have discounted the fall in recurring profits by as much as 39% that have been realistically expected by companies.