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EU shares rally not quite dead yet

Wednesday, December 18 14:12:34

Analysts are the most negative on European stocks in 20 years but that does not mean an 18-month equity rally in the region is dead in the water.

The number of "buys" as a proportion of analysts' recommendations on shares in the STOXX Europe 600 index has fallen to a 20-year low and the average rating to a three-year trough, Thomson Reuters Datastream data shows.

That reflects an unwillingness among analysts, who focus on stocks' fundamentals, to buy into a rally fuelled by easy money from central banks. But if extraordinary central bank measures bear fruit and Europe's fledgling economic recovery gathers speed, allowing corporate earnings to accelerate, shares could become attractive again.

"(Analysts') earnings expectations are high but they're bearish about their stocks because they think they are expensive," Andrew Cole, investment director at Baring Asset Management, said.

Recommendations and share prices, which normally move in tandem, parted ways in summer 2012, when bond buying by the European Central Bank and the U.S. Federal Reserve started to dull returns on debt and drive money into stocks.

Despite a stuttering economic recovery, European shares have surged 33 percent since mid-2012 to trade at 13 times their expected earnings for the next 12 months - the highest price/earnings multiple since 2009.

But with a dividend yield of 3.3 percent, the STOXX Europe 600 is still a more attractive proposition than Germany's 10-year Bund yield at 1.8 percent, even though that spread has narrowed from a record wide 247 basis points in June 2012.

"The market is prepared to pay a higher P/E for the time being against an environment where bond yields are seen as unattractive," said Cole.

Longer term, investors will need more evidence of a sustainable economic recovery or the rally would be doomed.

A Thomson Reuters StarMine consensus sees a 14 percent rise in European earnings next year, setting the bar high for further analyst upgrades, especially as euro zone inflation, a main driver of earnings, is low.

"The disconnect (between analysts and prices) either resolves with inflation expectations catching up, which is a real reflation, or stocks dropping hard," Michael A. Gayed, chief investment strategist at Pensions Partners, said.

Many strategists, however, are taking a more optimistic view, expecting central bank measures to shore up the economy, producing positive surprises in earnings growth.

A recent Reuters poll of strategists and forecasters predicts that a more durable economic recovery and accommodative monetary policy would help European stocks rally a further 12 percent next year.

That would assume no major economic shocks and European Central Bank stimulus averting the threat of deflation.

Alan Higgins, UK chief investment officer at Coutts, said signs of an acceleration in earnings growth could bring analysts on board and help push European equities' P/E multiple up to 14 times.

"If markets continue to go up I'm sure that you'll see analysts follow," Higgins said. "There's the momentum of the market and ... you'd expect some earnings to come through next year." (Reuters)