Earnings momentum strategies don’t work well at turning points in the economy, and they lost money in Europe during the second half of last year, but now that cheap stocks have been re-rated and PE multiples are compressed, Citi analysts think earnings momentum is back on.

“With the valuation gap between cheap and expensive stocks close to 25-year lows, we have suggested that earnings leadership/momentum will be a key driver of price leadership within European equities in the coming 12-18 months,” writes Citi analyst Jonathan Stubbs

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Autos, basic resources, banks, and insurance sectors give the best combination of low PE multiples and strong earnings momentum in Europe, while tech, travel and real estate also offer strong earnings momentum but with less attractive prices.

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Utilities upgraded to Neutral

Since the European economy has arguably just turned a corner (higher PMI and GDP estimates), it can be useful to look at earnings momentum delta as well to capture these changes. The same four sectors (autos, basic resources, banks, and insurance) still offer strong earnings momentum along with cheap valuations, but utilities has also made earnings momentum gains recently, causing Stubbs to change his rating on the sector from Underweight to Neutral. Citi had been Underweight on utilities since 2008, with a brief exception of July/August 2012, and while the industry still faces plenty of challenges from overcapacity, Stubbs argues that relative earnings may be stabilizing.

Tech, which has offered the best earnings momentum over the last six months, has the worst earnings momentum delta (defined here as the last three months’ earnings momentum minus the three months prior) and could be something of a trap.

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Forward cash flow strategies positive in 2013

Investment strategies based on forward cash flow (buying sectors with above average FCF yields) has also picked up again after a year of essentially flat returns in Europe, and FCF could be another way for sectors to differentiate themselves.

“This strategy worked well again in 2013 and has now outperformed in six of the last seven years. Now, this approach would be buying Basic Resources, Personal & Household Goods, and Health Care and selling sectors such as Oil & Gas and Chemicals,” writes Stubbs.

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Combining the two approaches, travel, basic resources, and construction have the best combination of FCF delta and earnings momentum delta. The only sector to show up as a strong sector from all three points of view is basic resources, so it’s no surprise that Stubbs is Overweight on the sector along with banks, insurance, and autos.

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