An unprecedented four years of double-digit returns on Australian equities has left investors in a state of disbelief.

Every year since 2003, when the S&P/ ASX200 returned a staggering 22 per cent, professional investors have attempted to cool people's expectations for the year ahead. And so it was at the end of 2005, when the domestic market gave back investors just over 17 per cent on their money.

Wise fund managers warned us "not to expect this kind of stellar return in 2006". They cited weaker commodity markets, rising inflation and subsequent interest rate hikes.

And yet, despite these warnings, 2006 turned out to be another stellar year on the home front. The S&P/ASX200 returned a whopping 18 per cent despite a mid-year correction and several interest rate hikes. The Australian equity markets stand at the dawn of another year and with four years of double-digit returns behind it fund managers are once more urging investors "not to expect this kind of return in 2007".

They talk of domestic overvaluation, a drop in commodity prices ahead and a slow down in earnings growth. It seems, however, that investors could at last be taking this advice to heart. Many believe domestic shares could well have run their course. They suspect many stocks could be nearing their full value and that the real opportunities lie outside Australia's borders.

"There is a general feeling that our market has run pretty hard and that investors will struggle to find value in 2007," Russell Investment Group investment strategist Andrew Pease says.

"The Australian market has compressed and there is not such a large spread between expensive stocks and cheap stocks. As such it has become more difficult for fund managers to find value."
Australian bears - when did you last see one?
A recent investor manager outlook report released by Russell backs up Pease's view. It suggested fund managers in Australia were heading into 2007 with a decidedly bearish attitude towards the home market.

The survey showed a strong preference among managers for international stocks over home-grown shares. Since the fourth quarter of last year, the survey showed, 65 per cent of fund managers in Australia were bullish towards overseas equities, as compared to just 28 per cent that were bullish towards domestic shares.

"Even though we have seen some of the more positive market conditions ever recorded, fund managers do not seem to be taking this purple patch for granted," Russell chief investment officer for Asia Pacific Peter Gunning says. "In fact, it seems many are grappling to find value."

Fund managers increasingly believe the home market to be overvalued. What had been a whisper in 2006 is rapidly becoming a shout. Of those managers surveyed, 37 per cent believed the domestic market to be overvalued, up 9 per cent on the previous survey.

Since many in the market are now agreed that the best returns could well be achieved overseas in 2007, the big question must remain: where?  Asia - all bull?
For Sean Henaghan, the director of AMP Capital's $18.7 billion Future Directions Fund (FDF), the answer lies in Asia.

AMP Capital is considering launching a dedicated Asian fund as early as April this year. The decision comes as part of a wider strategy to shift the FDF's international exposure to an overweight position in Asian equities.

"This is all about generating alpha opportunities from inefficient markets," Henaghan says. "We believe that Asian fundamentals are sound and the currencies are undervalued." The figures appear to back AMP Capital's view. On average, Asian equities returned 18 per cent to investors last year, compared to the rest of the world, which returned about 12 per cent.

ING Investment Management chief investment officer David McClatchy agrees. "We still see the Asian region as the pick of the emerging market world. Earnings growth, multiples and even yields are pretty exciting. There are some fantastic ineffi ciencies," he says. "The quality of earnings, the regulatory environment and structural changes have all had a positive eff ect on investment in the region."

However, picking the right Asian economy is not as easy as some might think. Citigroup's latest equity strategy report warns investors that if they had followed the consensus in Asia (ex Japan) since 1995 their portfolios would have underperformed by 0.3 per cent.

Ignoring the consensus and doing the exact opposite, according to Citigroup, would have resulted in investors' outperforming the market by 1.4 per cent over the same period. The biggest error rate has been in Malaysia and Thailand, the report says.

"Investors have been overly optimistic on Thailand 65 per cent of the time. While on Malaysia investors have been too bearish. Th is is why the consensus has been wrong more oft en than right. The consensus is currently still bullish on Th ailand, we are bearish. The consensus is bearish Malaysia, we are bullish," it says. Asian powerhouses
Elsewhere, China and India continue to attract worldwide interest. AMP Capital was the first Australian institution to offer domestic investors direct exposure to Chinese A shares with the launch late last year of its $280 million Capital China Growth Fund.

AMP director of Asian investments Kevin Talbot says the fund off ers an opportunity for Australian investors to tap into China's economic boom. "China's economy is now one of the largest and fastest growing economies in the world and is undergoing an economic transformation to a modern industrial economy," Talbot says.

Similarly, Australian investors can get direct exposure to India through two funds launched by Macquarie Bank and Globalis Investments in November last year. The funds invest in the so-called BRIC economies (Brazil, Russia, India and China) and aim to outperform the MSCI Emerging Markets Index over the longer term.

Positive sentiment towards international equity doesn't just extend to Asia. All across the globe analysts are optimistic about developed markets like the United States, Europe and Japan and the less developed markets of emerging Asia.

"The United States is unlikely to provide the highest pay-off opportunities - it is the weakest of the mature markets - but it will still give off positive numbers," McClatchy says. "We are also seeing exciting opportunities in Europe and the early stages of the re-emergence of Japan."  There's no place like home

Despite the seemingly boundless optimism concerning overseas stocks, many still believe investors' best bet lies in domestic shares. The spectre of infl ation-driven rate hikes eased at the end of January aft er Australia's headline consumer price index (CPI) fell for the first time in over eight years, pushed down by falling fuel and banana prices.

Australia's CPI posted a 0.1 per cent decline in the fourth quarter and the Reserve Bank of Australia's (RBA) core measure of infl ation, the trimmed mean, came in at the bottom of market expectations. The unexpected drop in inflation means few analysts now expect a rate hike from the RBA in February.

With the inflationary monster tamed for the time being, equity markets in Australia soared. At the time of writing, the S&P/ASX200 was cruising at 5769, almost 2 per cent up this year. AMP Capital head of investments and chief economist Shane Oliver is sceptical about deserting home-grown stocks in favour of potentially more volatile international shares.

"It's hard to get excited by global equities when compared to domestic stocks. There is a case to rebalance, but overall I don't see global shares outperforming Australian shares in 2007," Oliver says.

"The dividend yield in Australia is double that of international equities [4 per cent as compared to 2 per cent], plus franking credits add 1.5 to 2 per cent to returns in the home market." There is no doubt that, barring any unforseen disasters, international equities are set to post solid returns. But whether they will outperform Australian shares is a moot point.

Oliver says Australian shares are likely to provide strong returns over 2007 taking the share market to around the 6200 level by year end.

"Valuations are reasonable, profit growth is expected to slow but will still be solid at around 10 per cent and capital flows into the share market - on the back of merger and acquisition deals, superannuation flows and the investment of Future Fund assets - are likely to remain strong," he says. However, it would be wise to remain cautious.

Last June's equity market correction, when the S&P/ASX200 plummeted 12 per cent in a month, should have taught investors that nothing can be taken for granted in this world.