Do all bubbles have to burst? The recent caution shown by investors towards European shares seems to indicate their increasing uneasiness about the rapid rise in continental bourses.
Many of the European equity markets have recently come off their all-time highs as investors weighed the possibility of interest rate rises in the US and Germany. Even so, some analysts believe they remain too high. "I wouldn't chase the markets at these levels," says Mr Gary Dugan, European strategist at J.P. Morgan.
Yet, in spite of the visible froth seen in asset sectors namely, stocks and property of the so-called peripheral European markets (including Ireland, the southern Europeans and Finland), optimists point out that the present "bubble" might last for some time before deflating, rather than bursting.
"The secret of investing in the euro-bubble is to ride growth and inflation to maximum effect," says Mr Albert Edwards, strategist at Dresdner Kleinwort Benson.
The mismatch of interest rates which have been converging ahead of European monetary union has been the main cause of the equity rally. The convergence requirement of short-term yields under EMU has led to a fall in bond yields in countries which traditionally have been inflationary.
Markets such as Finland, the Netherlands, Ireland, Portugal and Spain have been beneficiaries as rates have fallen to the levels of German yields, regarded as the benchmark. Lower interest rates have increased liquidity in the markets while helping to boost economic growth.
The interest rate decline and rally in equity markets have also triggered a vast shift in funds within markets where investors have been used to putting money in bonds and bank deposits. In Italy and Spain, retail investors have been pouring money into equities by investing in mutual funds.
Meanwhile, the bull run has gained extra support from consolidation within industries, and a wave of mergers and acquisitions. More and more companies are now looking for acquisition opportunities to prepare for the disappearances of currency borders and the consequent opening of sectors that have been protected for a long time.
Cautious observers warn that European equity prices may have discounted the good news for now. "In too many cases, share prices have increased on the assumption that certain positive events will develop, be they earnings upgrades or M&A activity," says Mr Dugan. While shares should advance on a 12-month view, he is cautious in the shorter term.
Even so, the argument for buying is supported by expectations that the interest rate anomaly will continue in the medium term. Although European central banks and the Organisation for Economic Co-operation and Development have aired their concerns over asset inflation, euro interest rates are likely to lean towards maintaining growth in the core countries Germany and France and remain low, even if it causes overheating in some nations, including Ireland.
Although investors will need to check on economic recovery in Germany and France, economists believe this might not happen for some time. The core countries also have a larger exposure to Asia, and the recent weakness will drag down their corporate earnings. And while overheating can be tackled by fiscal policy, raising taxes to staunch liquidity is unlikely to be embraced by politicians.
Euro-enthusiasts seeking exposure may want to buy European funds with a large allocation to the peripherals. For the more cautious, playing Europe through companies with large networks on the Continent, might be a safer strategy. For those with a longer-term view, the currency could be something to keep in mind. An increasing number of institutions believe the euro will be strong against the dollar and sterling.
According to a recent survey by Merrill Lynch, fund managers in Britain and Europe see the euro as the strongest major currency on a 12-month basis while, even in the US and Japan, the opinion that it will be stronger against the dollar is gaining weight.
