Investors would do well to adopt a cautious position since there are still some doubts about the strength of recovery, writes Patrick Lawless.

The past year has been one of recovery for equity markets and, since it hit its nadir, the Dow Jones Industrial Average has risen 25.3 per cent and has recently broken the 10,000 barrier for the first time since May 2002.

Other markets have also risen and there seems to be a prevailing view that the tide has turned and that further market gains are in the offing in 2004.

But the outlook going forward remains extremely volatile and we believe that a repeat of 2003's performance by equity markets is unlikely.

As a result, we believe that investors would be well-advised to adopt a defensive strategy and focus on value as the most important factor when assessing investment opportunities.

Over the past year or so, the strong performance of equity markets has been driven by the strength of the US economy, particularly in the third quarter of 2003 when it recorded an annual growth in gross domestic product of 8 per cent.

But a cyclical upturn has followed and this had led to major structural imbalances within the US economy.

A low savings ratio, higher unemployment and a highly borrowed consumer may mean that the sustainability of US economic growth will be short lived.

Against this uncertain background in the US, Europe runs the risk of being forced to revalue the euro and this may undermine Europe's growth prospects. Although the current modest upturn may continue in the short term, this may fade as euro strength bites and domestic demand remains weak.

The prospect remains for the European Central Bank (ECB) to hold its refinancing rate at 2 per cent through 2004 with a small prospect of a small cut in the third quarter of the year. Although the recent breach of the stability pact has given the ECB the opportunity not to cut rates, low growth and the strength of the euro may force the bank's hand.

The Bank of England has operated a more successful monetary policy than either the Fed or the ECB, but it still remains concerned with the situation in the British mortgage market and historically high levels of consumer debt.

Present indications are that the Bank of England will raise rates by 0.25 per cent in the first quarter of 2004.

On a pure valuation basis, the UK trades on 13 times next year's earnings with potential earnings growth at 9 per cent.

Sterling looks underpinned at current levels and, as a result, the British market may offer some value at present.

In short, the outlook going forward remains uncertain and there is unlikely to be a repeat of 2003's performance.

Against this background, we believe investors should adopt a defensive strategy and value should be the most important factor when assessing investment options.

In 2003, shortly after the Iraq war broke out in March, earnings forecasts bottomed out a much lower level while on a sectoral basis cyclical stocks started to generate positive earnings news from low bases.

Currently, cyclical stocks are beginning to look fully valued on the basis of both price-to-sales and price-to-earnings multiples.

We would continue to recommend underweight positions in the TMT (technology, media and telecom) sector while on a price-to-earnings basis, technology ranks as the most expensive sector in the market with both software and hardware stocks trading at significant premiums to fair value.

At the other extreme, tobacco stocks - for those who do not have ethical objections - are trading at a 20-30 per cent discount to fair value, with excellent cashflow, low price-earnings multiples and good dividend yields characteristics of this sector.

Oil stocks are priced in anticipation of a severe cut in the oil price from the current $30 (€24) to about $21 a barrel.

However, next year is likely to see an increase in demand for oil. As with tobacco stocks, oil companies offer excellent cashflow and dividends in this sector are excellent.

Food producers have also lagged the overall market and more money may find its way into these companies as their defensive nature and cheap valuations become apparent.

And finally to banks. Their modest price-earnings multiples reflect concern that, should interest rates rise, this will reduce lending volumes and accelerate bad debts.

But given that we believe there will be no change in euro interest rates and only modest rate rises in the UK, we believe that these fears are overdone and that banks offer sound value investment opportunities.

Patrick Lawless is managing director of Appian Wealth Management. Appian, formed from a management buyout of Aberdeen Asset Management, is a private wealth manager and manages funds for pension funds, private clients, charities and credit unions.