Europe stock rally at risk as economy stays weak
* Central bank cash fuels index gains despite weak data
* Rally defies earning downgrades, nasty data surprises
* Market tolerance seen unlikely to last past year-end
By Simon Jessop
LONDON, May 21 (Reuters) - Central bank cash may not be enough to keep European stocks rising beyond the end of the year in the face of the region's weak company and economic performance.
The euro zone's longest recession and a weak earnings season have yet to erode double-digit stock gains, but investors' willingness to overlook the grim data is being tested.
A breakdown in the link between stocks and a gauge of how far economic data meets forecasts, weak business surveys (PMIs) and poor company earnings have led some to expect a dip.
That pressure could be amplified if talk U.S. monetary stimulus could be scaled back as early as mid-year proves true, even though returns on other assets remain relatively poor.
"For the last three quarters you've had disappointing earnings and yet the market in all three quarters went higher. That's unusual and unsustainable in the long run," Michael Barakos, chief investment officer for European equities at JPMorgan Asset Management.
"At some point, maybe the second-quarter or third-quarter earnings season, the game will be up, and either the earnings need to surprise on the upside for markets to sustainably move higher or otherwise equity prices will start to come off," added Barakos, who's firm manages $1.5 trillion in assets.
Placing greater focus on company performance, stocks are no longer "cheap". Europe trades on 12.4 times forward earnings, JPMorgan said, up 30 percent from mid-2012 and "very close" to the long-run average.
Stocks have rallied despite economic data lagging forecasts sharply - breaking the link between the euro zone blue-chip Euro STOXX 50 index and the closely watched Citigroup Economic Surprise Indicator that had held since 2009.
More companies have missed revenue and earnings forecasts in the first-quarter earnings season, winding down in Europe, than have met or beaten them, Thomson Reuters StarMine data showed.
The 1.3 percent average earnings miss in the STOXX Europe 600 is worse than in other regions and far below the 4.5 percent average beat of the last four quarters. On average, the revenues miss is 0.7 percent, also worse than over the year.
Given still weak PMI data, earnings are unlikely to recover soon, said James Butterfill, global equity strategist at Coutts: "If PMIs are above 50 they tend to result in delivered results beating expectations, and vice versa."
April's PMIs showed the euro zone downturn dragging on, while second-quarter corporate earnings forecasts have been cut an average 3 percent, StarMine data showed.
A willingness to look beyond the data and buy stocks as a source of income rather than as a play on future earnings has seen fund managers add to holdings in 2013, before cutting slightly in April, a Reuters poll showed.
While the market seems content to accept central bank largesse, Fredrik Nerbrand, global head of asset allocation at HSBC, said the gap between rising markets and weakening fundamentals "cannot keep widening", or a "sizeable" correction in stock markets was likely to occur "within six months".
"There's a larger and larger disconnect between the economic numbers, which are still not coming through in terms of delivering sustainable growth... and of how markets are trading," he added.
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