Not much joy for equity investors (page 1 of 2)

USA
The allegation of accounting fraud at WorldCom dealt another blow to investor confidence that has already been shattered by profit concerns, warnings about terrorist attacks and tensions in the Middle East.

Consensus expectations for 2Q profits have dwindled, down to a negative 0.2% on average year-on-year for the S&P 500 from last month's 1.2%. A recent poll of investor attitudes, falling sharply in June to its second lowest level in its history, showed that only 38% of investors were optimistic about the prospects for the financial markets over the next 12 months, dropping from 46% in May.

However, the economy offers bright hope, reinforcing our belief that the stock market will eventually return to its recovery path. The economy grew 6.1% for 1Q, and the consensus expects 3.5% GDP growth for 2H. Despite slower consumer spending in 2Q to a 2.5% rate, chain-store sales rebounded strongly during June, setting the stage for a stronger 3Q while mortgage refinancing accelerated, supporting consumer spending.

The ongoing strength of housing activity should precede an increase in the demand for home goods. Also, the fall in jobless claims to 388k, the fourth consecutive week below 400k, together with the expected pick-up in job growth, suggests that spending risks in 2H are probably to the upside. Capital spending finally turns up as new orders for capital goods jumped by 3.3% for May after rising by 1.4% for April. Tech orders rose for the third consecutive month, up 1% for May after jumping by 2.9% for April.

Finally, the Federal Reserve is unlikely to hike rate until probably in the November FOMC meeting when the recovery is firmly on track. Technically, the stock market's resilience in the wake of the WorldCom debacle suggests that it may be nearing a bottom and a potential rally is forthcoming.


Japan

The 12% drop of the TOPIX between the end of May and June 26 was because of a convergence of factors. Firstly, 47% of Japanese institutions were overweight their benchmarks in domestic equities, as a result of having increased their holdings during market weakness in January and February and the subsequent rally in the market.

Shares were sold to reduce their exposure - in May and June, trust banks alone sold Y445 bn of equities. Secondly, investors were disappointed by the government's anti-deflation plan announced on June 21 and the interim report on reform of the tax system. Thirdly, fears increased of a Middle East war or renewed terrorist attacks. Fourthly, the yen strengthened from Y125 to over Y120 to the dollar over the month, causing worries about the durability of the export-led recovery and the knocking stocks of exporters.

Finally, weakness in the U.S. market finally caught up with the Tokyo market. The Nikkei Average rallied strongly late in the week as gains on Wall Street and better-than-expected industrial output data at home triggered buying in technology shares. Japan's industrial production rose 3.9% in May, topping forecasts.

With Japanese valuations at record low levels and the cyclical recovery still on track, there is a chance that the Japanese market could decouple from the U.S. Price-to-book and price-to-cash flow measures are the two valuation metrics that have statistical validity. Price-to-book shows Japan is close to an all-time low, the cheapest when compared with the U.S. (higher than at any time prior to 1997) and Europe (slightly higher than in the 1984-1996 period).