Where we are in the cycle and why it pays to know

The Asian crisis came at a time when the US central bank seemed likely to raise interest rates and bring to a close what has been a golden era for the Dow and the All Ords. But this didn't happen. Financial markets have interpreted the Asian situation as moderating global economic growth and causing lower currency and commodity prices. This has prolonged the period of moderate economic growth with low inflation and reduced the likelihood of central bank intervention raising interest rates.

This is a favourable environment for company profits but there's something else too - with low interest rates, dividend yields become comparatively more attractive to investors. In other words, the Asian crisis has extended what has been a good few years.

What of the future?

This scenario sets the scene for further gains by our sharemarket over the next few months. Company profits are growing satisfactorily (an average of 14% net profit growth by industrials in the reporting season just concluded), Gross Domestic Product this calendar year should beat the Government's forecast of 3.75% and underlying inflation is running at only 1.4%, a 35 year low. Liquidity is another important driver and this too is a good sign with favourable investment flows and an acceptable amount of new equity issues and floats (estimated 5% of market capitalisation).

But this won't last forever. In fact later in the year things could get a little tricky. The lagged impact of the Asian economic turmoil is likely to be an increasing focus for investment markets as more of its effects are felt, bringing renewed volatility. A slower global economy will undermine global equity market valuations if stock earnings are revised downwards.

Dow rises 124% since February 95

The US market is already overvalued by around 15% based on current bond rates and earnings forecasts, so US company earnings are the key for the Dow. This is a concern as the momentum of their profit growth is already slowing, and profit margins are threatened by rising labour costs and lower international competitiveness brought about by the higher US dollar. So watch the US for profit downgrades!

The Dow has already risen 124% in the bull run since February 1995 and unfortunately, history tells us that it's impossible to stall the investment clock forever. The fact that the Australian All Ords has underperformed the Dow (only up 50%) is small comfort – it's largely due to differences in the two indices including the large component of (underperforming) resource stocks in the All Ords.

Furthermore, things on the domestic front may be starting to deteriorate. As the economy slows and exports to Asia falter, the current account deficit will start to be more of a concern as it moves towards 5% of GDP, putting the Australian Dollar under further pressure, and could create market volatility, especially with an election around the corner.

If bond rates are seen to be at their low, the sharemarket will need better than expected company profits to justify a higher market and that's hard to see given the slowing economy and the Asian situation. Don't forget the Asian situation is likely to affect Australia more than most other countries - Asia comprises 40% of our export markets and our sharemarket is more exposed to commodities than others. This may keep some international investors on the sidelines.

Australian investment institutions are holding around 12% in cash at the moment – which is quite high given the low returns for cash. We suggest you have close to 20% of your investment portfolio in cash. This will give you security and funds to take advantage of buying opportunities if and when they arise.

What to consider and what to avoid

As mentioned in the last issue, high-yielding stocks like banks, insurers and utilities continue to stand out. They still provide better income returns than money in the bank and this should support their share prices even in times of uncertainty. Also consider stocks that have a higher chance of achieving their earnings forecasts. This may include utility companies and organisations like Brambles, Lend Lease, Westfield Holdings, Coles Myer and Woolworths. On the flip side, cyclical and so-called recovery stocks could continue to underperform.

Look at service and consumer oriented companies rather than manufacturers because their earnings stem from faster growing and more protected sectors of the economy. Similarly, domestic based stocks are also more protected from the fallout.

While resource stocks seem to represent reasonable value, uncertainty over commodity prices leaves them with uncertain earnings, and this erodes confidence in their values. Industrials still look the better long-term bet.

Of course, it's not all doom and gloom, far from it. There's still plenty of opportunities to be had. But when you're talking about money, a cautionary approach usually pays. Fortune may favour the brave, but it doesn't necessarily make them rich.