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Global Stock Market Outlook

- Alan Lavine and Gail Liberman

There's plenty of cash going into overseas stocks.

Global equities are being supported by buoyant liquidity at a time when fund managers are still cautious about the outlook for corporate earnings, according to Merrill Lynch's Survey of Fund Managers for November.

Fund managers remain concerned about the outlook for corporate earnings despite some stabilization in the overall growth prospects for the global economy. At the same time risk appetite has improved and, despite the 10% rally in equity markets over the past three months, managers still have cash to put to work. For the market to rally in the face of this corporate-earnings uncertainty suggests that investors are comfortable with letting higher equity valuations take the strain. The fieldwork for the survey closed on 9 November and does not fully reflect the impact of US Congressional and Senate elections.

"What is interesting is how equities are rallying at a time when investors are struggling to see how corporate earnings could surprise positively over the coming year," said David Bowers, independent consultant to Merrill Lynch. "The good news for investors is that cash levels remain robust, and it is this liquidity that is allowing valuations to take the strain."

Average cash balances have risen to 4.1% from 3.8% in October. The net balance of investors taking overweight positions in cash rose from 18% to 21%. Risk appetite has recovered too. The net balance of investors reporting higher-than-normal levels of risk has risen from minus 32% in August to minus 14% in November.

In addition to these buoyant cash balances, the majority of the panel continues to believe that yield curves will turn more positively sloped over the course of the coming year. Following some renewed concern about inflation after the recent run-up in commodity prices, a net 13% of respondents expect short rates to be higher a year from now whereas a net 33% expect long yields to rise. The conventional wisdom equates more positive sloping yield curves with easier monetary policy and strong equity-market performance, despite evidence that bonds tend to benefit more.

Although expectations for global growth have improved, investors struggle to see how corporate profits can surprise positively over the coming year. A net 47% of investors believe that corporate profits worldwide will deteriorate in the coming year, and that the primary driver of profits growth will be cost-cutting. Inevitably, this means that for equities to rally, valuations have to take the strain. For the first time since 2004, more investors see equities as overvalued as opposed to undervalued.

Investors' regional preferences have undergone some profound changes over the past 12 months. Asset allocators have shifted focus from Japanese to Eurozone equities. A year ago Japanese equities were regarded as having the most favorable corporate-earnings prospects, and considered one of the most undervalued regional markets in the world. But over the past year Japanese equities have underperformed by 8%, not least because of a weaker-than-expected Japanese yen.

Merrill Lynch believes, however, that the Japanese economy is well-positioned for 2007. Jesper Koll, chief Japan economist for Merrill Lynch says: "Our growth forecast is significantly stronger than the Bank of Japan, both for full year 2006 and full year 2007." Merrill is forecasting 2.5% GDP growth for 2006 and 2007.

Today, Eurozone equities are deemed to have the most favorable corporate-earnings prospects, and represent one of the most undervalued equity regions in the world. While optimism towards Eurozone equities is nothing like as extreme as it was towards Japanese stocks in the fourth quarter of 2005, Japan's experience over the past year counsels caution. In particular, investors should consider the consequences for Eurozone equities should the European Central Bank tighten further and Eurozone growth disappoint.

"We don't expect growth in the Eurozone to surprise on the upside as much in 2007 as it has in 2006", observed Klaus Baader, Merrill Lynch's chief Europe economist. "And we are confident that rates will hit 3.75%, probably in the first quarter of next year, with the risks skewed to possible further interest rate rises later in the year."


Spouses Gail Liberman and Alan Lavine are syndicated columnists. Their latest book is "Rags to Retirement (Alpha Books)." You can e-mail them at MWliblav@aol.com.

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