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Peering beyond the gloom

Second-quarter earnings reports and a recent decline in oil and food prices have offered hunkered-down investors some encouragement to start looking beyond the deep market gloom for potential bargains.

Results so far from most US banks and from major corporations on both sides of the Atlantic have surprised on the upside, evading the catastrophe some investors had discounted.

Once-unstoppable oil prices fell $18 at one point last week after hitting record peaks above $147 a barrel earlier this month, while the closely-watched index for commodity markets fell nearly 9% from its record high set in July.

After hitting a 21-month low and plunging deeper into bear market territory, MSCI's world equity index ended the week up for the first time in seven weeks.

“The bear market is already advanced and equity markets appear cheap,” said Tony Dolphin, director of economics and asset allocation at Henderson Global Investors.

Dolphin said under a normal cycle, inflation fears should ease towards the end of the year, creating scope for interest rates in Europe to come down in 2009 and setting the scene for a revival in economic growth.

“At some point equity markets should recover in anticipation of such an outcome. The second half of the year will not be easy for investors but it could turn out to be less bad than the first half,” he said.

The corporate earnings slate this week includes Bank of America, Wachovia, Boeing, Pepsico, Pfizer, Vodafone and GlaxoSmithKline.

News flows over the past week have betrayed those investors who embrace a doomsday scenario.

Top US banks Wells Fargo, JP Morgan and Citigroup all posted better-than-expected results, while IBM reported forecast-topping profits and raised its estimate for this year.

On the macroeconomic front, the International Monetary Fund unexpectedly revised up global growth estimates for this year and next, saying the world economy would expand 4.1% in 2008.

An emergency rule from US regulators to curb short selling in major financial firms - due to come into effect on Monday - has also helped to take pressure off markets.

“When fear grips markets, reverse trumps is a favored game and there is a rush to downgrade everything, regardless of fundamental value or historic precedent,” State Street said in a note to clients.

“Institutional investors, however, are less panic-stricken. They are striking a relatively composed note as all around them heads are being lost.”

Credit Suisse has raised US equity markets to 10% overweight from 5% previously, having gone overweight on Wall Street for the first time in a decade earlier this year.

Strategists at the Swiss bank see Wall Street as defensive and it outperforms 70% of the time when the rate of growth shown by global leading indicators is below 2%.

“Above all, US corporates are able to cut costs more quickly than corporates in Europe or Japan. US monetary conditions are the easiest in 20 years - in Europe, they are the tightest for 17 years - and the dollar is very cheap,” the bank said.

It also believes Japanese stocks offer a hedge against credit, inflation and oil because the country is the most energy efficient of the major economies.

Barclays Capital's sentiment-based equity risk indicator currently suggests a 77% probability that equities continue to sell off aggressively, down from 82% last month.

Valuations analysis backs the argument that equities have fallen to a level which would attract buyers as equity markets from Australia to Belgium have entered bear market territory by falling more than 20% from their cycle peaks.

In Lehman Brothers' calculations, world equities in aggregate trade at 12.2 times forward earnings, or 11.9 times without Japan. That compares with a price/earnings ratio for the MSCI world stocks index of 16.4 last July, just before the credit crunch took hold, according to Thomson Reuters data.

However, Lehman does not conclude that last week's relief rally in riskier assets will be a finale to the bear market.

“Viewing capital market valuations as participant referendums on future economic and corporate conditions, the cyclical yellow flashing light has now turned red,” Lehman said in a note to clients.

“The magnitude of the ultimate global fundamental downturn may not yet be fully appreciated. The psychological recovery from portfolio and issuer valuation damage of this magnitude will be recorded over multiple quarters ... The equity and credit gods are hardly smiling.” (Reuters)