European Stock Market Rally to End, Strategists Say

By Alexis Xydias and Adam Haigh

Jan. 7 (Bloomberg) -- The best start for European stocks in at least two decades will give way to losses as slumping corporate profits send equities to new lows, the biggest securities firms say.

The Dow Jones Stoxx 600 Index’s 7.3 percent surge in 2009 through yesterday was part of a so-called bear-market rally that will end as earnings deteriorate, according to Morgan Stanley and Merrill Lynch & Co. Profits at European companies will tumble 20 percent this year, Goldman Sachs Group Inc. says.

The Stoxx 600 rebounded 17 percent since Nov. 21 on speculation U.S. President-elect Barack Obama will revive the world’s biggest economy with $775 billion of tax cuts and spending as the European Central Bank and the Bank of England lower interest rates to combat the biggest financial crisis since the Great Depression. Stocks gained even after data showed manufacturing and service industries in Europe are contracting at the fastest pace since data began in 1998.

“This is a bear-market rally, it is a chance to sell rather than to buy,” said Teun Draaisma, the London-based head of European equity strategy at Morgan Stanley. “The fundamentals are in big trouble with the economy.”

Morgan Stanley, ranked second by Europe-based investors in last year’s Thomson Extel survey for global-equity strategy, says stock prices don’t yet reflect the drop in earnings. The rally pushed the Stoxx 600’s valuation to 9.8 times the profits of its companies, compared with a ratio of 7.9 on Oct. 27.

European stocks fell for the first time in seven days today, with the Stoxx 600 retreating 1 percent to 210.79 at 8:59 a.m. in London.

Writedowns, Recessions

The Stoxx 600 slumped to a five-year low of 182.13 on Nov. 21 as credit-market losses and writedowns at European financial firms climbed toward $300 billion and the U.S., Europe and Japan fell into the first simultaneous recessions since World War II.

Europe’s regional benchmark rebounded after the U.S. rescued New York-based Citigroup Inc. The gains accelerated over the last six days as governments from Washington to Beijing and New Delhi stepped up efforts to boost global growth. The advance to start the year was the fastest since the Stoxx 600’s data began in 1987.

Stocks rallied as analysts reduced their outlook for earnings. On the day the Stoxx 600 reached its 2008 low, analysts projected profits at companies in the index would climb 4.5 percent in 2009, data compiled by Bloomberg show. They now estimate earnings will slip 0.8 percent.

For U.S. companies in the Standard & Poor’s 500 Index, analysts estimated a profit rebound of 4.3 percent this year, Bloomberg data show.

‘Chase the Market’

Strategists are more bearish on Europe, with New York-based Merrill Lynch and Goldman Sachs estimating profits will fall at least 20 percent in 2009. Morgan Stanley, also based in New York, says earnings may tumble as much as 43 percent from their peak.

“My concern is that we had a rally from the depths of late October and November but we are still too optimistic for earnings in ‘09,” said Neil Dwane, who oversees $80 billion as chief investment officer for Europe at Allianz Global Investors’ RCM unit. “I would not chase the market from here,” he said in a Bloomberg Television interview yesterday in London.

The 505 European companies tracked by Bloomberg that announced earnings since the Stoxx 600 began its rebound in November posted a 75 percent decline in average profit.

Economic Deterioration

Morgan Stanley’s Draaisma forecasts European shares will make little headway in 2009. While Merrill Lynch and Goldman Sachs estimate that share prices may reach fresh lows in the coming months, they say European benchmark indexes may climb 13 percent and 20 percent, respectively, for the full year if credit markets recover and the pace of economic deterioration slows.

Recent data give little indication that a rebound is imminent.

A survey of purchasing managers by London-based Markit Economics yesterday showed a composite index of Europe’s manufacturing and service industries dropped to 38.2 in December, the lowest since the survey began in 1998. Separate data showed U.K. services from restaurants to airlines shrank at close to the fastest pace in at least a dozen years last month.

The global recession may prompt the Bank of England to reduce its key interest rate tomorrow to an all-time low of 1.5 percent from 2 percent, according to economists surveyed by Bloomberg. The ECB has reduced its benchmark rate by 1.75 percentage points to 2.5 percent since October.

“Investors will buy back into the markets on any good news in early 2009,” Merrill Lynch’s London-based strategist, Karen Olney, wrote in a report dated Jan. 5. The rally triggered by government and central bank efforts “will be capped and could unwind” in the first two quarters, Olney added. “Profits gained should be taken.”

To contact the reporters on this story: Alexis Xydias in London at axydias@bloomberg.net; Adam Haigh in London at ahaigh1@bloomberg.net