Shares in telecoms and utilities have returned to the top of European equity investors' menu, signalling that a shift away from outperforming financials and automakers may be afoot as the economic recovery matures.

A move from cyclicals to defensive stocks such as drugmakers, telecoms, and food producers, which have better ability to weather the economic downturn, would be akin to calling an end to an eight-month-old stock market rally.

And many investment managers, who had missed the early part of the rebound, prefer to stick to the best performing shares until the year end for fear of falling further behind in this year's performance.

But a growing numbers of investment banks have urged clients to look to some defensive laggards, as 2010 could be volatile with central banks expected to withdraw their ultra-loose monetary policy by the end of next year.

"The market is starting to rotate away from (cyclicals) towards the opposite where valuations are lower, where the performance has been much worse," said Philip Isherwood at Evolution Securities in London, who feels that the market has moved from discounting recession to discounting recovery.

The rally which has seen the pan-European FTSEurofirst 300 rebound 57 per cent since early March has been led by miners, banks, insurers and construction stocks - the worst hit during the financial crisis in 2008.

That has seen some sectoral valuations, as measured by one-year forward price-to-earnings (P/E), rise above their pre-crisis level in 2007.

European banks gained 60 per cent from the start of the year to October 20 and insurers rose 21 per cent. But since then, they have lost 4.3 and eight per cent respectively.

By comparison, telecoms have gained 0.3 per cent since October 20 after gaining a mere 7.8 per cent from the start of the year. Utilities, the worst sectoral performers this year, have produced 0.8 per cent returns in the past month versus a 1.6 per cent drop for the DJ STOXX 600.

"The first six, seven months of the rally was led by high beta and cyclical sectors. We think the process is changing," said Ronan Carr, European equity strategist at Morgan Stanley.

"Some of the defensive stocks are starting to do better. It's one of the reasons why we are favouring consumer staples."

The broker upgraded food and beverages and tobacco to "overweight" from "underweight".

Food producers, trading at a one-year forward P/E of 16.7 versus 17.1 in 2007, have also outpaced financials and automakers in the past month, up 1.6 per cent. Elsewhere, JPMorgan moved cyclicals versus defensives to "neutral" from "overweight" and Citigroup downgraded basic resources to "neutral" from "overweight".

In terms of valuations, banks have a forward P/E of 14.26, compared with 10.37 in 2007, according to Thomson Reuters data. Telecoms, by comparison, have a one-year forward P/E of 11.03, down from 14.1 in 2007. Many fund managers, however, are not prepared to give up their positions in cyclical stocks yet, with 2009 drawing near.

Playing a momentum-based strategy near the year-end - going long on the outperformers and shorting the underperformers - had more than 50 per cent chance of success, Societe Generale said in a report last month.

"The problem is people are chasing performance now, and so buy the cheaper, maybe more defensive sectors relies on you calling the market turning," said Neil Dwane, chief investment officer for Europe at Allianz's RCM. "I don't think the shorter term people are prepared to make that call."

Mr Dwane, who expected a L-shaped recovery in most markets, said the rotation to defensive stocks from cyclicals may not happen anytime soon.

"The market may wish to retain this position for maybe the next couple of months until it realises that the scale of the challenge that it has believing it's a V-shaped recovery when it isn't," he said.

Mr Dwane said he would look to firms that can tap into government infrastructure spending, such as miners, though some in the sector were expensive. Miners, with a forward P/E of 21, are the best performers this year, up 88 per cent.

Nevertheless, analysts agreed that at some point, the shift would happen with the possible removal of government stimulus programmes next year and the recovery of dividend, making stocks that have a higher payout ratio more attractive.

"Right now we're in a twilight zone because the market is awash with liquidity," said Ad van Tiggelen, senior strategist at ING Investment Management. "As long as we're in this strong liquidity-driven phase, it's probably too early to turn really defensive, but it is almost without doubt the next big move.

"It's quite certain that in 2010 the defensives will outperform again, especially the high dividend yield, large cap defensives."