Valuation based on forecasts is the most important factor in our view, determining developments of individual equities and equity markets withina multi-year time framework. Over shorter periods, earnings mo-mentum and earnings revision trends are seen as most important.
Markets that are cheap on our valuation indicators and display a positive earnings revision trend are overweighted and markets with the opposite characteristics are underweight-ed. When signals are conflicting, valuation guides the longer-term strategy, whereas earnings trends determine shorter-term implementation. To establish valuation levels for markets, we use indicators developed in-house linking return on equity, price-to-book ratios and the level of bond yields.
Working with this approach we ar-rive at a more positive assessment of the US equity market than appears to be the consensus among European fund managers. After the correction, the market is now only slightly expensive on our indicators and well supported by earnings trends.
A revival of inflation would certainly quickly erode the valauation basis for the market. Our assessment, however, is that the disinflationary forces of intense global competition and productivity-enhancing capital spending will continue to operate on the US economy. These forces have been strengthened by the currency devaluations and economic weakness in the Asian region. The Asian developments have also increased worries on the earnings front for US corporations. Presently, this negative impact influences our portfolios more in the stock selection dimension than in the overall assessment of the market.
We are also constructive on the outlook for European equity markets. Valuation levels are broadly in line with those in the US according to our measures and earnings trends are distinctly favourable. Conditions now exist in Europe for a healthy rate of growth over the coming years.
A possible future threat to sustained positive equity markets in Europe is the inefficiencies in labour markets. As economies revive there is a risk that equity valuations could be eroded by higher inflation and interest rates.
Asian equities are underweighted in our portfolios. Japanese equities would represent attractive values only under the assumption that current low levels of interest rates are sustainable - a view that we do not subscribe to. In addition, the earnings trend is unfavourable and in our judgement is likely to remain so over the coming 12-month period.
Smaller Asian markets have been heavily sold down and could produce interesting trading opportunities in the near term. However, the underlying cause of the Asian crisis in our an-alysis is over-investment over recent years and therefore over-capacity to-day. This capacity overhang will need considerable time to be reduced, even as demand revives. Also, much expansion has occurred through an increas-ed rate of borrowing. This is now causing considerable damage to balance sheets in the area.
In summary, we are overweighted in the US and European equity markets, without any great distinction be-tween the two areas and and underweighted in Japan as well as in the smaller Asian markets. Our valuation criteria currently guide us to a neutral position between bonds and equities.
Hans Danielsson is chief investment of-ficer with SE Banken Fonder in Stockholm