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World market balancing act
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 Global stock markets seem to have shaken off their summer worries over the past few weeks. With this change in mood has come not only new, or at least recent, highs for some of the world's major indices but, we believe, a fundamental shift in the type of stocks likely to lead further advances.
In recent weeks, the Dow Jones Industrials Index has surpassed the previous all-time high of 11,722 set in the dying days of the last bull market, while the FTSE 100 has hit a five-year high of 6,172, closing in on its all time high of 6,930, set on 31 December 1999.
This recovery has come despite the return of political risk to the agenda. In recent weeks a military coup has ejected Thailand's prime minister, Thaksin Shinawatra, Hungary has suffered riots and in Russia, the government has made another move to increase state control of its energy resources by threatening to cancel operating licences at Shell's huge Sakhalin-2 joint venture on environmental grounds.
But politics aside, the fundamentals continue to hold sway and this is why markets are making progress. In particular, we believe markets are starting to recognise that we have probably reached a peak in US interest rates. Bond markets currently suggest that the next move will be down, in early 2007. The Federal Reserve has not changed its language substantially with regard to inflation - the job market is still tight - but it has started to acknowledge that a severe correction is happening in an overheated housing market.
As has been widely documented in the press, the US housing market has been driving job creation in recent years and has propped up consumer activity - the central pillar of the US economy - at a time when households' savings rates have dipped into negative territory.
It is too early to tell just how serious the property market slowdown might be. The precedents in the UK and Australia suggest that market activity can cool off without undue damage to the overall economy.
Similarly, the US property market is highly localised and subject to a wide range of differing dynamics, so it is unlikely to change uniformly.
Even though the market is pricing in lower interest rates, the Fed is unlikely to signal a cut until it sees clear signs of inflation pulling back from 11-year highs or if the housing market slowdown spills over into other parts of the economy.
On the latter, US consumers have so far been more responsive to a fall in petrol prices rather than a fall in the perceived value of their homes.
Another positive for markets has been the strong levels of corporate profitability, both in the US and elsewhere.
So, while we continue to believe that a midcycle slowdown may be the most likely scenario in the next few months, we are increasingly positive on the outlook for world markets.
We do, however, believe that some significant portfolio changes are required to make the most of the next phase of this bullrun. While cyclical sectors may have had the best of the current three-year-old bull market, growth stocks now look better placed than for a while. We have been making some major changes to our portfolios as a result to this expected change in leadership. Key among these has been a move to increase our position in the US.
While the Dow Jones Index has reached record highs, this does not indicate that US stocks are looking expensive. The Dow is a pretty meaningless index, because it is price weighted (as opposed to market cap weighted).
The big money tracks the S&P 500 index anyway and that is still some way short of a new high. We think that US equities offer good value on an earnings yield basis relative to bonds and expect this market to make good progress as sector leadership changes.
We have, however, retained our position in Japan. While Japanese stocks suffered a stronger correction than other major markets over the summer, we are confident that the continued recovery in the domestic economy will lead to an improvement in valuations over the coming months.
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