Asian markets have been stuck in a trading range for almost a year: MSCI Asia ex Japan is up only 6% since the end of July 2009. We think the sideways market is likely to persist for a while yet. With earnings forecasts being revised down, PMIs falling from their cycle highs, liquidity drying up and lots of new issuance, especially in China and India, it's hard to see a reason why Asian equities should boom over the coming months. And, while valuations are cheap, they are not as super-cheap as in some other markets. Asia ex Japan is on a forward PE of 11.8x, but that is not so far below the average since 2001 of 12.5x and much more expensive than Russia (5x) or Brazil (9x).

Not that we are bearish. Asia's long-term story remains attractive. Growth in China, India and other Asian economies is likely to remain well above that in developed economies for years to come, with fewer structural risks. In the near term, our economists do not foresee a double dip. As long as earnings growth comes through, Asian stocks can continue to rise steadily. We forecast 8% upside in regional indexes to year-end, and recommend a neutral weighting versus a global benchmark.

Our country allocations focus on long-term growth stories with reasonable valuations. We continue to think Korea offers the best risk/reward trade-off in Asia: investors pay the lowest price of 8.9x forward PE for above-average EPS growth in 2010 of 49%. Indonesia's structural story and high ROE make it attractive, too. We raise Australia to overweight as a cheap, lower risk way of gaining exposure to China. We cut Japan to underweight as it will suffer from cyclical softness and a strong yen. We are neutral on China, and cut MSCI Hong Kong to neutral, too, since excess liquidity is drying up. Our biggest underweight remains India, which is expensive and has the biggest inflation risk.

Our sector recommendations remain pro-cyclical and have an above-market beta. Our focus is on long-term growth stories, such as industrials, which will benefit from a growing capex story in Asia, consumer discretionary and materials. Our only change this quarter is to cut IT to neutral from underweight. Demand for tech is still strong, but additional capex will increase supply, and earnings expectations have run ahead.

David Fuller's view The conclusions in this report are cautious. This is certainly understandable and may be appropriate under the international economic circumstances. However, with two exceptions I remain impressed by the resilience of Asian stock markets during a 17 percent correction by Wall Street from its April high. The exceptions are China and Japan due to their specific and separate problems of supply and deflation, respectively.

I had been saying recently that western stock markets were oversold. On Monday we saw the first upward dynamics to signal a rally, which commenced in Asia. Wall Street was closed due to the July 4th holiday weekend and US investors tested the lows on Tuesday before joining the rally. I maintain that western investors have overdone the double-dip story.

The S&P currently shows a failed break beneath lateral trading near 1050, although not by a sufficient margin to reverse the gloom. The bounce to date is mostly due to short covering. However, cash levels are high and if bargain hunting and perhaps momentum buying pulls wary investors back into the market, this would bode well for in-form Asia where I would let price action reveal the upside leaders. If I am too optimistic and the S&P breaks beneath 1000, all upside bets are off until 4Q.