Investor/An insider's guide to the market: News that Angela Merkel is to be the new German chancellor was greeted with a yawn in the financial markets.

The euro fell 0.5 per cent on the day of the announcement to $1.2052, and there was no perceptible reaction in the German stock market. There are fears that much-needed labour market reforms could be substantially diluted under the proposed grand coalition of the Christian Democratic Union (CDU) and the Social Democrats (SPD).

The German stock market has in fact been very strong in 2005 and is up by approximately 20 per cent year-to-date. The calling of an early general election by the outgoing chancellor, Gerhard Schröder, was welcomed in the market as the early polls gave the reforming CDU a big lead. The CDU campaigned on a platform of major economic reform to pull Germany out of its high unemployment rate and low economic growth quagmire.

The hung parliament that ensued was not the result that investors in Germany hoped for, but surprisingly, the political uncertainty had only a minimal negative impact on German shares. In fact, the German market has been one of the better performing European equity markets since the end of the bear market in 2003.

From its bear market low of 2403, the Dax30 index has gained 110 per cent to its current level of 5060. This is still almost 30 per cent below its all-time bull market high of 7128, indicating that historically, the German market has been more volatile than many other large stock markets.

Given the well-publicised problems that have beset the German economy for several years, the recent strong performance of the market may come as a surprise to many. German economic growth in 2004 was a sub-par 1.1 per cent and forecasts for growth in 2005 and 2006 are not much higher than 1 per cent.

Therefore, an improvement in macroeconomic conditions offers no explanation for the booming stock market. Likewise, political developments cannot explain strong German share prices, even though the change of government does give some cause for qualified optimism regarding the pace of structural reforms.

The only plausible explanation for strength in the German equity market over the past year resides with the behaviour of corporate Germany itself. Firstly, quoted German companies are highly export-oriented and have taken full advantage of the rapid growth of world trade in recent years.

The weakness of the euro in 2005 has injected a further competitive boost, enabling German companies to gain market share.

Secondly, corporate Germany has embraced structural reform irrespective of the rigidities of the broader political process.

These positive factors have fed through to improved German profitability. The net earnings of quoted German companies are forecast to rise by over 20 per cent in 2005 and by a further 12 per cent in 2006.

This is better than the European average, where corporate profit growth forecasts hover around 15 per cent for 2005 and 10 per cent for 2006.

This recent and prospective strong profit growth means that German equities still offer attractive investment value, despite the recovery in share prices. The 2005 price earnings (p/e) ratio for the Dax30 is 14.7, which is slightly lower than the long-run historical average.

This is only slightly higher than the p/e ratio of 14 for the Dow Jones Stoxx TMI index, indicating that German shares are priced in line with their European peers. The 2005 dividend yield on the Dax30 is estimated at 2.6 per cent, which is just a little below the European average.

Like many other equity markets, the strong rise in share prices over the past year means that German equities do not offer prospective investors compelling value. Nevertheless, if the new government can even achieve partial success in its reform programme, it may inject new life into Europe's largest economy.

This, combined with ongoing corporate reform could be sufficient to sharply improve the medium-term prospects for the German equity market. In Investor's view, the German risk reward balance is still favourable and the German equity market continues to offer attractive upside potential.