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Europe's Economy and Stocks—The Great Divide

Jenny Cosgrave, Staff Writer
Wednesday, 8 May 2013 | 8:57 AM ET

European stocks hit their highest level in almost 5 years on Wednesday, boosted by better-than-expected industrial output data from Germany.

The German DAX hit another record high, extending gains made on Tuesday.

But behind the stock market rally has been plenty of weak data from the euro zone in recent weeks, raising questions about whether the market momentum can continue.

German services PMI data released on Tuesday, showed the index shrank below the 50-point level, signalling a correction for the first time since November, following the steepest drop in new business for six months. Chris Williamson, chief economist at Markit pointed out that France, Italy and Spain also recorded contractions in business activity, while the broader euro zone figure showed that the downturn in the region was dragging on.

(Read More: Germany Backtracks on Banking Union)

"The PMI suggests that, having eased in the first quarter of the year, the euro zone's economic downturn is likely to have gathered momentum again in the second quarter," said Williamson.

Neil Wilkinson, European growth fund manager at Royal London Asset Management said markets were currently in an environment where monetary policy was outweighing economic fundamentals.

While, he said, valuations were still reasonable for stocks, they were likely to get more expensive.

"The price to book 10-year average of the MSCI ex-Europe price is currently 1.65 and we are trading on about 1.25 at the moment based on year-end 2013 earnings, but we could easily reach that 10 year average," he said.

(Read More: Why the ECB Is 'Stupid' Europe's Best Hope)

Dan Morris, Global Market Strategist, J.P. Morgan Asset Management said the poor value investors were getting in bonds was likely driving more people into stocks.

"There is the argument that the stock market is anticipating the recovery, but I don't think that is what is happening here, it is more of a reflection that there is not much value to be found in fixed income at the moment," he said.

"One factor influencing the performance of stocks in Europe is the perceived country risk. A high dividend yielding stock in Spain is likely to perform differently than a stock with an equivalent yield in Germany," said Morris.

"In Q1, when the U.S. market gained 10 percent, Europe advanced just over six percent, even though the higher dividend yield on the European index (3.7 percent vs. 2.2 percent), should have made it more attractive," he said.

Morris said if you separate country risk (measured by 10-year government bond yields) from dividend yield, generally the highest returns are associated with countries with comparatively low country risk, such as Germany.

By CNBC.com's Jenny Cosgrave. Follow her on Twitter @jenny_cosgrave.

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