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Sentiment in financial markets is often primarily driven by either greed or fear, but lately it appears to be driven by both at the same time. This is especially the case in Europe. On the “greed” side we see strong equity markets in which economically sensitive stocks (so called cyclicals) have soared, without any apparent concern for their valuation. On the “fear” side we see European government bond markets in which investors appear increasingly concerned about Greece and some other Eurozone members, a development with potentially dire consequences. What does this imply?

Let’s first have a look at the equity markets. In spite of their strong recovery since March 2009, they still appear to be reasonably valued, as earnings have been much better than expected. However, the rise in equity markets has largely been driven by cyclicals and financials, whose share prices have mostly doubled or tripled since their lows. Traditional defensive sectors such as utilities, telecoms and pharmaceuticals have lagged massively. This has caused cyclicals as a group to trade at one of their most expensive levels versus defensives in the past thirty years. The reason for this development is twofold:

- In periods of economic recovery investors look much more at the momentum in earnings per share growth than at the valuation level of equities. Positive earnings surprises are greeted with enthusiasm! This approach now favours cyclical stocks, even if defensives look much cheaper.

- US and European cyclical stocks tend to derive a growing portion of their earnings from foreign sales (emerging markets!), whilst sectors like utilities and telecoms are mostly domestically focussed. So defensives profit less from the spectacular growth in emerging markets than cyclicals.

The latter observation is one of the key reasons why sentiment on European equity markets has been able to partly decouple from sentiment on European government bond markets: companies can globalise but countries cannot.

On the one side, investors have embraced this phenomenon by highly rewarding international companies for their better than expected earnings. On the other side, they are increasingly nervous about highly indebted countries which run deficits.

We think that it is highly unlikely that these two developments will coexist peacefully for a very long time. After all, investors tend to be very good at exaggeration, of greed as well as fear... until a breaking point is reached. On the equity side they are constantly lifting their earnings expectations for cyclicals for 2010 and 2011, to levels which are unlikely to be reached in the end. This is a ritual which we have also seen in previous cycles. In the mean time, investors increasingly keep punishing the weaker Euro members with higher bond yields, threatening the refinancing of their debt and the homogeneity of the Eurozone. This is a “ritual” which is new and which brings many uncertainties.

What to do? Investors could consider reducing the risk profile in their portfolios, given the high uncertainty around the Eurozone developments. This does not only apply to bonds but also to equities. We still believe that a very gradual switch from expensive cyclicals (like industrials and retail) into high quality stocks with defensive characteristics is a wise move. In Europe, we prefer stocks with a high foreign (non euro) sales component in areas like food/beverages, oil, pharma and technology.