Germany's benchmark Dax share index closed at a near five-year high on Thursday, near the end of a year in which European equities have outpaced global and US rivals for the first time since the depths of the global economic crisis.
The resurgence in equities shows how investors have re-rated euro zone break-up risks following a pledge by Mario Draghi, European Central Bank president, to safeguard the euro zone's integrity.
European stocks are up almost 4 percent so far this quarter, while US equities are down 2 percent, according to their respective benchmark indices. Over the year so far Europe has now cantered past the U.S., with more than a 15 percent total return on the MSCI index compared with less than 14 percent in the US.
The rally remained intact even after gloomy ECB growth forecasts released following the central bank's interest rate-setting meeting in Frankfurt.
"Equity investors see that the ECB is following a policy of cheap money to stabilize the currency union," says Jorg Kramer, chief economist at Commerzbank in Frankfurt. "That will also be positive for the growth outlook and Germany will outperform the euro zone."
Yet the trend has little to do with an improving euro zone economy – and many analysts also expect earnings-per-share figures for European companies to fall or at least stay flat next year.
Instead, the ECB's "outright monetary transactions" – or bond-buying – program, launched by Mr Draghi in September, has reassured investors a backstop was in place to shore up the euro zone if needed, even if the program has yet to be activated.
"The risk of some cataclysmic implosion has receded since the summer, and that is basically what has been driving stocks higher," says Bertie Thomson, senior fund manager at Aberdeen Asset Management. "Risk premiums have fallen sharply."
Mislav Matejka, European equity strategist at JPMorgan, adds: "It is not that there is likely to be much growth in the eurozone next year but that the stocks are undervalued compared with global peers, so they have some real catching up to do."
At the start of the summer the ratio of the price to forward-looking earnings was just 8.4 for stocks on the MSCI Europe index compared with 11.3 on the comparable US index. But in recent months, following the ECB move, this ratio for European equities has risen by nearly 30 per cent to 10.8 times. The move has brought valuations more in line with US stocks, which have a ratio of 12.8 times.
In another sign that investors have become more sanguine, equity market volatility in Europe is at its lowest level in five years. The Vstoxx index, which measures market expectations for volatility, has been hovering at about 16 for the past week, its lowest level since 2007.
Some analysts see the outlook for euro zone equities as depending crucially on politics, given that growth in the eurozone economy is forecast to be tepid at best. "To repeat the summer's performance, we'll need another piece of good news on the politics," says Nick Nelson, global equity strategist at UBS.
Still, there are signs the rally in European equities has also been driven by hopes that the financial stability provided by the ECB and better prospects elsewhere in the world will eventually feed into the euro zone real economy.
Germany's Dax index, which has risen 28 per cent this year to its highest value since January 2008, is positioned to benefit most from improvements in the global economy, given its companies' exposure to export markets.
Mr Draghi, for his part, cited surging European share prices as a sign of financial confidence returning to Europe's monetary union. At his regular monthly press conference in Frankfurt, he also pointed to improvements in business confidence across the eurozone's main economies, although he stopped short of predicting a turnround in the region's weak growth prospects.
The ECB revised down significantly its forecasts for eurozone economic growth, saying it expected the pace of next year's contraction to be in a range with a midpoint of minus 0.3 per cent. In September, it had expected a 0.5 per cent expansion.
However, eurozone purchasing managers' indices this week suggested the worst of the eurozone recession was over, although they still pointed to a sharp economic contraction in the final three months of this year. Germany, meanwhile, on Thursday reported an unexpectedly steep 3.9 per cent rise in manufacturing orders in October compared with September.
Deutsche Bank this month advised investors to buy global cyclical stocks in Europe, forecasting that global growth of 3.5 per cent would drive shares higher in 2013. The bank tipped companies including SKF, the Swedish ball bearings maker, and BASF, the German chemicals company, as likely to be some of the best performing stocks next year.
In 2012 European financial and insurance stocks have been among the best performers, says Mr Nelson at UBS. "If the PMIs are right that the economy is at a turning point, it could be time to rotate out of financials and into some of the more economically cyclical parts of the market."