Is the European Rally a Bear Trap?

Fundamentals are lousy -- but there are a few good buys

Call it the relief rally. Stock markets in Europe, like those elsewhere, have staged a robust, if erratic, recovery since it became clear that the U.S. and British were on track to win a decisive victory in the war against Iraq. Between Apr. 1 and Apr. 7, the MSCI Europe index surged almost 15%. And although stocks lost some ground on Apr. 8 and Apr. 9, most money managers predict further big gains in coming weeks. Kai Franke, a strategist at ING-BHF Bank in Frankfurt, thinks Germany's depressed DAX index could rise as much as 50% above its prewar lows.

Did the war put an artificial damper on European equities straining to escape from a three-year bear market? Yes, say some market analysts, who argue that war fears, by undermining consumer confidence and sending oil prices rocketing, neutralized attempts by the European Central Bank and euro zone finance ministers to stimulate Europe's economy through interest-rate cuts and government-spending hikes. That, in turn, took its toll on shares.

Skeptics, however, think the bulls could be in for a nasty surprise. Once the war is over, they say, investors will shift their focus from Baghdad back to the economic fundamentals. And they are not going to like what they see in Europe, where the indicators look bad on all fronts: Unemployment is rising, business confidence is slipping, and gross domestic product in the 12 euro zone nations will be hard-pressed to grow by 1% this year. Company profits aren't likely to grow more than 5% in Britain and 3% on the Continent, analysts forecast. Michael Hartnett, director of European strategy at Merrill Lynch & Co. in London, expects the post-Iraq headlines to be dominated by what he calls "SARS" -- not the virulent Asian virus, but "Spreading Accelerating Recession Signals."

If he's right, it may be premature to declare the rebirth of equities. "Stocks are in the throes of a bear market rally that will peter out in a month or so," says the chief investment officer of a Swiss insurance company. Trevor Green, a money manager at Allianz Dresdner Asset Management, one of Europe's biggest institutional investors, says, "this could be the classic year to sell in May and go away." Green says investors should be especially wary of some sectors, among them hotel chains and banks, that blame their recent lackluster performance on the war but are really suffering from bad management. "The war has muddied the waters for investors," he says.

Still, even pessimistic investors expect some European industries to shine. One is pharmaceuticals, where companies such as Switzerland-based Novartis (NVS ) and Britain's AstraZeneca PLC (AZN ) will probably continue to benefit from strong demand even if the economy remains sluggish. Another is mobile telephony, led by stars such as Vodafone Group PLC (VOD ), based in Newbury, England.

For stock-pickers, the secret of success in this uncertain environment is to spot the jewels in the rough -- well-managed companies in underperforming sectors that boast sound strategies and proven records. For instance, money managers say bank shares in general aren't likely to hold up once the postwar euphoria dies, but well-run institutions such as Switzerland's UBS (UBS ) will sparkle. Although most energy companies and utilities will fall back, German utility RWE and British gas company BG Group PLC (BRG ) may continue to outperform.

For those Europeans convinced that stocks are a good buy, their home markets may be a better bet than the U.S. That's because European equities, especially in Germany and France, fell further during the bear market and are now cheap by comparison. What's more, currency traders say the recent recovery in the dollar is likely to lose steam, with its value driven down by the U.S.'s yawning current-account deficit. HSBC analysts expect the euro to strengthen from $1.07 on Apr. 9 to $1.20 by yearend. That means European investors who buy U.S. stocks could be exposed to punishing exchange-rate risk.

One thing is certain: These are confused and volatile times for markets. The hope among many money managers was that the end of the Iraq conflict would send a clear signal. But in the investment wars, it's still tough to tell who's winning.

By David Fairlamb in Frankfurt

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