LONDON, 29 September 2003 — After looking at equity markets from a technical perspective last week, let us examine this week what the earnings and economic picture tells about the current state of the stock market. The MISCI World 12-month forward earnings estimates were revised upward by 1.1 percent in September and are continuing their uptrend. Accelerating volume and revenue growth amid subdued costs of production help firms to operate more profitably. Surging productivity aids companies to keep their costs in check.

The reported earnings growth is especially encouraging when considering that a new US tax bill, authorizing firms to employ accelerated depreciation, is now in place. Since firms are actively exploiting this tax minimization opportunity, the scale of reported earnings growth is surprising. After all, the newly instated measure was only expected to boost cash flows. Free cash flows are highly scrutinized by the investment community - an encouraging sign for the stock market.

Besides higher productivity, earnings revisions by analysts were primarily motivated by a better economic environment. Recently, most US economic indicators have picked up in speed. The purchasing manager index rose in August for the fourth time in a row, suggesting now real economic growth of over 4 percent.

Sales rose stronger than inventory holding. Inventories are now at a new historical low. We expect a stimulating effect on the economy by the low inventory/sales ratio. Manufacturers will attempt to run up their inventories to a normal level. The only factor in the economic picture that we are somewhat concerned about is the moderate confidence of consumers. Continuing job losses and rising gasoline prices in the US are not helping people to gain trust in the economy. In spite of subdued consumer sentiment figures, however, we are still optimistic for the aggregate economy.

Europe is sending out positive economic signals as well, the ifo index, which measures the business confidence of manufacturers, rose in August for the fourth consecutive month. Since earnings estimates of stock analysts usually lag economic developments, a further rise in stock prices can be expected. Although stocks have risen faster than earnings in the recent months, the MSCI price/earnings ratio is only yet approaching its historical average. With earnings trending upward, there is still great potential for rises in stock prices.

Let us look at the two most expensive sectors in the MSCI World (price/earnings ratios still significantly above average): Information technology and telecom.

The telecom sector is overvalued. In spite of the low interest rate environment, we are concerned about the chronically high debt levels of many firms. Furthermore, structural overcapacity, and the intensive competition plague our confidence as investors in the sector.

Although the IT sector trades at a comparably high P/E ratio and had a strong rally in 2003, we regard the sector as being valued fairly. Earnings growth rates implicit at current stock levels are reasonable. In addition, various technical indicators are pointing to further rises of IT stocks.

In regards to the allocation between bonds and equities we still recommend favoring stocks over bonds. Although equity risk premium recently dropped as a result of rising interest rates, it is still comparatively high. We define the risk premium as the relationship between the earnings ratio is the reciprocal value of the P/E relationship.

As mentioned above, we also like equities because we expect the earnings momentum to continue amid the sound economic development that we are currently witnessing. Furthermore, equities are supported by the significant inflows of capital into the asset class. From a technical viewpoint, the trend channel of most equity indices is still in tact - in spite of the recent price correction.

— (Habib F. Faris is vice president at Clariden Bank, London.)