It’s time to buy up European stocks

At first glance, Europe does not look promising for equity investors. Eurozone GDP fell by 0.1% in the third quarter after a 0.2% drop in the previous three months. An index tracking activity in the service sector has declined to a 40-month low. Germany's widely watched Ifo business confidence indicator is at its second-lowest level since early 2010, pointing to virtual stagnation in the eurozone's biggest economy.

With consumption in Germany and France set to weaken as German unemployment ticks up and French austerity kicks in, the recession is likely to get worse, warns Capital Economics. It hardly helps that consensus earnings forecasts still look too high. With the growth outlook darkening and profit margins already at a 15-year high, according to Citigroup, earnings are hardly going to grow by 11.6% next year. A slight decline is more likely.

Despite all this, European stocks remain a promising investment. For starters, the odds of a chaotic, unplanned break-up of the single currency, triggering a Lehman-style collapse, have greatly receded. In July the European Central Bank president, Mario Draghi, promised to do "whatever it takes" to keep borrowing costs tolerable for the indebted periphery by buyingunlimited quantities of its bonds. "Markets now have the confidence that, when push comes to shove, European politicians will find a solution," says Graham Secker of Morgan Stanley. "That was not the case a year ago."

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Remember too, says Buttonwood in The Economist, that Europe is full of firms "selling goods and services to emerging markets and their prospects are thus not entirely moribund". Dividend yields are also at appealing levels. The FTSE Eurofirst 300 index yields 3.9%. In Austria, Switzerland, Sweden and the Netherlands, shares yield more than ten-year government bonds and have far more scope for capital growth and protection from inflation.

Finally, initial valuations matter more for long-term returns than the short-term economic outlook. The cyclically adjusted price/earnings ratio (CAPE), the price divided by the average earnings over the past ten years, has a solid record. The cheaper the CAPE when you buy, the higher returns will be. Europe's overall CAPE hit a 30-year low of 11 in June and many markets are still in the high single-digit range. These presaged juicy gains in America when they appeared in 1982 and 2009. Given all this, we would continue to buy income-bearing European stocks on market weakness.