OBSERVER/ECONOMY: We have read a lot recently about the flight out of the dollar, out of the US equity markets and, as usual, a lot of hype suggesting that the end of the world (in the US anyway) is nigh. We say nay to the naysayers.

All but six of America's S&P 500 companies have reported Q1 numbers and so far 62 per cent of these top companies have beaten analysts expectations with only 16 per cent falling short of forecast.

Hard numbers are the perfect answer to those who remain negative. Many of the more respected US analysts are now pointing to further positive earnings news, expected when the next round of results are released in the summer.

The analyst consensus is that earnings will rise by 7.3 per cent in Q2. But still the market is not responding. The Dow Jones and S&P indices continue to struggle despite a general acceptance that stock markets normally flag a change in economic fortunes up to 18 months before it happens.

But investors are adopting a "show me" approach suggesting that the market discounting mechanism may be less forward-looking than usual. Why? The explanation is easy - confidence levels. Investors remain uncertain about the earnings outlook for the second half of the year. Their biggest worry is about "end demand" - real consumer and corporate demand. Company inventories being run down rather than the crucial pick-up in consumer demand has fuelled the recovery to date.

What is needed now is an improvement in corporate confidence and in capital investment. Concerns have been raised that second-quarter economic growth has moderated from the heady growth experienced in Q1. This has played into the hands of the "double dippers" - those who believe the US economy is on a second slide back into recession.

The worriers have been making much of the "alleged mismatch" between the US economy and US corporate earnings. Q1 GDP growth appeared huge while corporate earnings were still declining. But there is no conflict in these figures - earnings are compared year on year while economic growth is compared quarter on quarter. Earnings grew quarter on quarter in Q1 in line with the economy's growth.

Sales growth was negative year on year during Q1 and indeed was even more negative than during Q4 2001. But the rate of decline is slowing. This is crucial - while revenue is still declining the leverage or geared effect of prior cost cutting is still difficult to gauge. But the benefits of cost cutting will become crystal clear when companies can exhibit top line growth.

This will become apparent in the second half of the year as companies, which have a fixed cost base spread out over the number of items produced, will see output increase while their fixed costs are unchanged allowing for a boost in margins per item produced. Once sales growth emerges there will be a sharp earnings rebound.

What the market really needs is the conviction that final demand will remain firm, that capital spending picks up and stays up while the consumer sector remains firm, in essence the pattern of typical economic cycles. Expectations for Q3 and Q4 are already high though confidence in these forecasts is low in the market. But there is no disconnect - the Federal Reserve, the bond market and the dollar have exhibited similar concerns.

The sharp gains in productivity have been entirely passed on to the consumer via lower prices and while this has allowed the consumer to remain firm through the toughest industrial downturn in history it has obviously not helped the US corporate sector.

The performance of the defensive sectors (food, beverages, healthcare etcetera) could suggest that investors are losing confidence in the extent and/or timing of the recovery with a concern that the consumer sector could slow down before the industrial sector recovers. This is not our view but the recent moves in the bond market, the dollar and in interest rate expectations suggest the market is becoming less enthusiastic on the economic outlook.

The stock market is trading on a 2002 price/earnings ratio of 20.7 times our earnings estimate. While this is not cheap on an absolute basis one has to remember that the relative price of the asset matters. This p/e compares with bonds, which are trading on very low yields as justified in an environment of continued low inflation and interest rates. Our view is that the market is not expensive.

The markets require leadership. Company trading updates given during summer may be the catalyst to drive markets higher. Also important will be economic data releases, which should confirm that a new multi-year economic and business cycle recovery is under way. We do not believe the economy will double dip. The recovery will continue and with it earnings, confidence, leadership and stronger equity markets. The world hasn't ended.

Noel O'Halloran is chief investment officer at KBC Asset Management