INVESTOR/Markets: Stock markets around the world have been experiencing a severe bout of weakness over recent weeks.

The extent of this investor nervousness has been such as to stimulate the G7 leaders to reiterate that economic growth has resumed in order to calm the markets.

As always, it is difficult to accurately pinpoint the main cause for this further bout of share price weakness. Up to the end of May, the majority of equity market indices had already declined since the beginning of the year.

For example, the S&P 500 index in the US had fallen by 9 per cent and in Europe the FTSE Eurotop 300 had dropped by more than 7 per cent. A key factor creating this share price weakness has been weak financial results from many companies, both large and small.

Furthermore, a high proportion of companies stated that they expected the rest of the year to remain difficult. Added to this weak background regarding corporate profitability, there has been a continuous stream of revelations concerning the accounting practices of many once high-flying companies.

Not alone are investors worried about the prospects for growth in corporate profits, they are also seriously concerned about the veracity of the financial statements produced by many companies.

Virtually every stock market in the world has suffered from the impact of this close scrutiny of the accounting practices of one or more of their respective constituents.

On the Irish market, the near 90 per cent collapse in the Elan share price explains the bulk of the year-to-date weakness of the ISEQ.

The US stock market has been particularly hard hit from the fallout surrounding the accounting scandals at Enron Corporation.

By the end of May, there was reason to believe that share prices had discounted much of the bad news regarding corporate profitability. The catalyst for the recent bout of weakness would seem to be fears that interest rates in Continental Europe and the UK are about to rise. Recent statements from the European Central Bank (ECB) and the Bank of England indicate that central bankers are worried about potential future inflationary pressures.

Equity markets generally do not rise during periods of rising interest rates as higher rates entice investors to hold a higher proportion of their assets in bank deposits or government bonds. Therefore, expectations that interest rates may rise sooner rather than later is undoubtedly a negative influence on equity markets.

Reassurances from the financial authorities that the major economies are now growing solidly have done little to improve market sentiment. This is a little surprising since stronger economic growth will normally lead to a recovery in corporate profits. If investors take the view that corporate profitability is about to improve, they will generally commit funds to equities even if interest rates are about to rise.

We therefore need to look elsewhere for explanations as to the current pervasive weakness in global equity markets. Heightened political tension around the world is certainly playing a part.

However, a key financial factor lies in a growing acceptance among stock market analysts that share prices are still overvalued despite the declines of recent years.

This "overvaluation" problem is particularly acute in the US stock market. From 1992 through to early 2000, the US stock market experienced a strong and sustained rise in share prices. The most popular yardstick for judging value in share prices is the price-earnings ratio (PER) which reached a very high level at the height of the stock market boom.

The share prices of many companies in the technology sector were trading on PERs in excess of 100 times earnings. The only way that high PERs can be justified is if corporate earnings are to achieve very rapid rates of growth.

The problem facing investors now is that the average US company is still trading on an historically high PER of over 20 times earnings whereas over most periods for which data are available, US share prices have traded on a lower PER, averaging around 15 times annual earnings.

During the stock market boom of the late 1990s, investors were prepared to accept high valuations (high PERs) because they believed that profits would grow very rapidly.

Now, however, investors are much more sceptical of companies' ability to achieve rapid profit growth in the future. Therefore, the "value" inherent in share prices needs to improve, which would imply lower PERs.

If growth expectations remain subdued, the only way that "value" can improve is if share prices decline. In other words, investors will be enticed to purchase equities only if prices decline to a lower level than current levels. It does seem, therefore, that current equity market weakness is due to this process of "valuation adjustment" rather than a very weak global economic environment.