European equities, after digesting S&P’s downgrade of France, had to contend with rather tepid GDP growth during the third quarter. The European Union’s statistics office said GDP of the 17-nation euro area rose only 0.1% compared to 0.3% in the previous quarter. The region therefore avoided a contraction by a hair’s breadth, justifying the ECB’s recent action to cut interest rates.

The Yellen effect on European equities

European equities may have wobbled but were lent a hand Thursday by Janet Yellen’s dovish statements before the Senate Banking Committee. She came out strongly in favor of quantitative easing, saying it was “imperative to do what we can to promote a strong economic recovery,” and that the program had made a meaningful contribution to economic growth and to the improving outlook.”

Yellen’s stance boosted European equities Friday, particularly banks. Societe Generale SA (EPA:GLE) (OTCMKTS:SCGLY), in France was up 0.9% at €41.40 while Credit Agricole SA (EPA:ACA) (OTCMKTS:CRARY) added 0.6% at €9. Spanish bank CaixaBank SA (MCE:CABK) (OTCMKTS:CIXPF) rose 2.3% to €3.48. Italian bank Banco Popolare Societa Cooperativa (BIT:BP) (OTCMKTS:BPSAY) gained 0.5% to €1.30. Across the Channel, Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) (AMS:RBS) was higher by 1.2% to 330.4p, while Barclays PLC (NYSE:BCS) (LON:BARC) was up 0.7% to 251.7p.

What do these developments mean for investors in European stocks, which have clocked gains for the last 5 weeks? Is the rally at risk given the poor GDP show?

A new value strategy for investors

Citi analysts Anna Esposito, Jonathan Stubbs and Ayush Tambi call for a shift in European portfolio strategy by placing an emphasis on earnings leadership instead of chasing the value/risk rally.

“With the value gap between expensive and cheap stocks compressed within Europe, we think earnings leadership (and hence earnings momentum) will drive performance leadership in the coming 12-18 months,” say the analysts in their November 14 study of European equities.

According to the analysts, improvement in Europe’s macroeconomic conditions over the recent past sparked a sharp rally that chased value at historically low risk, but it may now be time for investors to return to earnings momentum strategies.

Investors may adopt a two-pronged strategy to unearth value, they say:

  • Buy sectors which trade at a discount to the broad market on a P/E multiple basis, and/or,
  • Buy sectors that are trading cheap in the context of their ‘normalized’ P/Es (that is to say, looking cheap versus their own earnings history)

Sector road map

Here’s how the sectors look when plotted on a grid for PE and momentum.

1-sector-map European Equities

Investors should look for opportunities in the sectors falling in the lower right hand quadrant – these are cheap but have strong earnings momentum.

Citi’s models throw up two lists of stocks that meet the above strategies.

1. 2-first-strategy European Equities

2. 3-second-strtegy European Equities

However, the Citi analysts qualify their recommendations, saying, “Earnings momentum strategies tend to work well over the long-term, especially when macro volatility is low or when macro trends are consistent,” and point out that “a new leadership group which is more pro-cyclical/financial and anti-defensive than before,” may be emerging.