European Stocks Will Rely on Banks in 2008

European stocks had a turbulent second half in 2007 and are still in largely in recovery mode as the year draws to an end.

But equities could move higher in the first quarter of 2008, especially if troubled banks signal an end to the credit crunch.

"We're pretty positive about next year. We think it will start slowly, but will get a lot better as we get through the first couple of months," Max King, investment strategist at Investec Asset Management told CNBC.com.

Strong valuations and earnings forecasts, along with supportive bond yields are the positive factors, according to King.

A big sign that stocks are set to turn higher would be a recovery in the battered banking stocks, King added. Banking has been one of the worst performing sectors of the year, down 16.8 percent, according to DJ Stoxx Sector index.

"The real test for next year is working out when you buy the financials," King said.

Howard Goldring, managing director of Delmore Asset Management, echoed the sentiment, saying "the biggest question for 2008 … is when the investment banks will turn … that will probably mark a rather large change in the market and a change in investor confidence and perceptions."

The turning point for banking stocks could happen when investors are sure that all the bad news from the credit crisis has been released.

"I'm hoping that in the first few months of 2008 the banks will come clean and say exactly what they've lost … as soon as we actually know what the downside is, we can start building further to the future," Steven Mayne, head of research at Montague Pitman Stockbrokers, told CNBC Europe.

European stocks have been volatile ever since the subprime lending crisis in the U.S. resulted in a tightening of global credit in September.

But a healthy amount of volatility is necessary for stock performance, and the amount of volatility 2007 was pretty modest, King said.

However, the FTSE-100 only eked out a gain of 3.8 percent for the year, while the CAC-40 edged up 1.3 percent for the 12 month period. The DAX enjoyed a strong performance, gaining22 percent, despite the shaky conditions, but the German index is in the minority amongst its European peers.

Andmany market watchers are cautious about thecoming year and fear slowing growth in the U.S. economy will see the world's biggest consumer whither under the pressure of a weak housing market and rising inflation.

"The market is designed to go up, (but) does that mean we are going to keep on going up over the next twelve months? I'm slightly skeptical," Mayne said.

Central Banks to the Rescue?

The interest rate strategies of Europe, the UK and the U.S. will provide a constant backdrop for next year's markets. And whether they choose to fight inflation or boost economic growth will be of paramount importance.

"The European Central Bank will stay on hold for next year," Nathalie Fillet, interest rate strategist at BNP Paribas, told CNBC.com, but added that "we already have a much more neutral rate (than the US)."

The Federal Reserve and Bank of England are widely expected to continue reducing interest rates next year for fear of worsening the impact of the credit crunch, buy Fillet argues that it is too early for the ECB to assess its impact.

"For the time being we are still waiting on the impact of the credit crisis on the real economy," Fillet said.