European stocks rise on hopes of Draghi bond buys, China stimulus

European stocks ended higher on Monday, extending the previous session's rally as investors' hopes of further stimulus measures from central banks overshadowed grim manufacturing data from China and Europe.

The FTSEurofirst 300 index of top European shares ended 0.8 percent higher at 1,091.61 points, with the index experiencing its lowest trading volumes since last December's Christmas week, due in part to the fact that Wall Street remained closed for a public holiday.

The euro zone's blue chip Euro STOXX 50 index added 0.9 percent, to 2,463.17 points.

The rally was broad based, with French pharma group Sanofi adding 2.2 percent and Italian lender UniCredit gaining 1.7 percent.

Despite figures showing the euro zone manufacturing sector contracted faster than previously thought last month and data from China signalling that the pace of the country's economic growth will weaken well into the third quarter, investors continued to focus on this week's European Central Bank policy meeting.

The ECB is expected to unveil details of a plan to buy bonds from Spain and Italy to lower the two countries' borrowing costs and ease the region's debt crisis.

On Monday, ECB President Mario Draghi was reported as saying that the purchase of sovereign bonds with a maturity of up to three years by the central bank would not breach EU rules, easing worries about the plan's potential hurdles.

Despite Monday's gains, Francois Chevallier, strategist at Banque Leonardo, warned that equities will struggle to extend their rally started in late July.

"The ECB's plan to buy bonds is pretty much priced in at this point. The risk is now on the downside, if investors are disappointed by the central bank's programme or the conditions attached to it," he said.

"The price-to-earnings ratios have gone up, due to rising prices but also to eroding analyst forecasts, which is seriously limiting the upside potential for stocks."

VALUATIONS AT 18-MONTH HIGHS

The sharp equity rally started in late July - sparked by comments from Draghi about potential bold measures to help fight the debt crisis - has propelled European equities to valuation ratios not seen in 18 months.

The euro zone's blue chip Euro STOXX 50 index is trading at 9.85 times 12-month forward earnings, a level not seen since March 2011, while the broader STOXX Europe 600 index trades at 10.88 times expected earnings, its highest price-to-earnings ratio (P/E) since April 2011.

However, both European indexes still trade well below their 10-year average P/E ratios - 11.23 for the Euro STOXX 50 and 12.37 for the STOXX 600. European blue chips also remain cheaper than stocks from emerging markets, with the MSCI emerging equities index trading at 9.94 times expected earnings.

By comparison, Wall Street's S&P 500 trades at a 12-month forward P/E ratio of 12.77.

Despite the recent strong gains, investors pulled over $1 billion out of Europe equity funds in the last week of August, according to EPFR Global, a research firm which tracks both traditional and alternative funds globally.

EPFR also signals a strong rise in investors' appetite for hedges, as investors move to protect their portfolios.

RISING RISK AVERSION

"With volatility so low and recent portfolio gains to protect, investors have been buying volatility funds in recent weeks amounting to about $1 billion of inflows," EPFR Global Managing Director Brad Durham wrote in a note.

"The bets are paying off as the VIX gapped higher during the last two weeks of August."

Reflecting a similar trend in Europe, the Euro STOXX 50 volatility index, Europe's main gauge of equity market investor anxiety, surged 3.7 percent on Monday.

The volatility index and the Euro STOXX 50 usually move in opposite directions, but the VSTOXX has gained more than 25 percent over the past two weeks while the Euro STOXX 50 is only down 1.3 percent over the same period, signalling a rise in investors' risk aversion despite any significant pull-backs in stocks.

"(The volatility index) is bouncing from what was quite a low level hit in July, but that being said, its recent rise is a sign that a lot of investors are bracing for a market correction. It bodes ill for equities in the next few weeks," a London-based volatility and derivatives trader said.