(Bloomberg) -- European stocks are near a four-year high and technical indicators suggest that the rally may have gone too far. But some signals still favor a market ignored by investors for much of this year.
Fueled by the optimism over U.S.-China trade talks, the Stoxx Europe 600 has outperformed the S&P 500 this fall and is now heading for its best year in a decade. However, even the latest gains look modest in relation to a $100 billion investment exodus from the region’s equity funds in 2019.
“Positioning was weak in Europe this year, investors maintained a very prudent stance as a result of perceived high political risks,” said Stefano Zoffoli, Zurich-based chief strategist at Swisscanto Invest, which oversees about 160 billion Swiss francs ($161 billion). “This is something that could underpin the markets in the next three to six months.”
So while the market is up 20% this year, investors have been pulling money out of European-focused stock funds almost non-stop since March 2018. This mood started to shift in mid-October when the optimism of a Brexit deal and a global rotation into value stocks fueled three weeks of inflows of about $3.3 billion.
After Bank of America Corp.’s fund manager survey showed for months that European equities were one of the world’s biggest underweight positions, in November the allocation jumped to the highest since August 2018.
Valuations also continue to speak in Europe’s favor, according to BofA’s Manish Kabra. The strategist said the equity-bond yield gap in Europe remains near a 100-year high and euro-area stocks are trading at a 50-year low relative to global peers in terms of performance. BofA is overweight on euro-area and U.K. stocks.
“Europe is still full of extremes fundamentally,” said Kabra, head of European equity strategy at BofA. “We are suggesting to stay long and ride through the technical reversions at least until the German bund yields move to positive territory.”
The return of investment inflows into equities over the past few weeks has been global, according to Citigroup Inc. strategists. “November is on track to be the first month of inflows into emerging and developed market equities funds in two years,” the strategists wrote in a note.
Some traders on Wednesday took profit on their European equity returns as the Stoxx Europe 600 fell as much as 0.8%. Alberto Tocchio, chief investment officer at Colombo Wealth SA, said he’s been selling European stocks and buying protection through put option spreads and volatility.
“It’s time to take profit and go long volatility to best protect the portfolios,” said Tocchio. “Markets are currently very overheated. There is little room for a negative surprise from these levels.”
Technical indicators are raising the alarm, with the 14-day relative strength index of the Stoxx Europe 600 on Tuesday closing above 70, the level some analysts see as a signal that the security is overbought and poised for a retreat.
The economic slowdown in Germany, tensions in U.K. politics and risk of a re-escalation in U.S.-China trade war pose a threat to the nascent popularity of European equities. However, on Wednesday data showed that euro-area industrial production unexpectedly rose for a second month in September, offering a sign the economy is beginning to emerge from a slump.
JPMorgan Chase & Co. strategists raised euro-area stocks to overweight in late September and continue to recommend using pullbacks to add to holdings.
“Many want to fade the move, but we advise against it as we are likely to see PMI improvement over the next months, and yes, the outflows were significant,” said JPMorgan’s Mislav Matejka, referring to Purchasing Managers’ Index economic data.
At least for now, the stock market that until recently had very few fans, remains a place of optimism for asset managers.
“Our valuation work continues to favor European stocks,” said Andrew Cole, head of multi-asset at Pictet Asset Management in London. “Economic growth expectations are low in Europe with room for easy beats, aided by monetary and fiscal stimulus.”
(Updates with a quote from JPMorgan strategist in the 14th paragraph)
--With assistance from Sid Verma and Cecile Gutscher.
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