Europe is cheap for a reason

After last week’s review of the U.S. stock market, we examined other markets to determine where the bargains might be.

Europe is as cheap (based on price-to-earnings) as it has been in a long time. There’s serious political uncertainty in 2017 and the consensus says “Europe is cheap for a reason”.

But, as a contrarian trade, is it time to buy European stocks?

You can review last week’s note here to see how expensive the U.S. market has become, at least when stock prices are measured in a ratio to a 10-year average of cyclically-adjusted earnings. As everyone knows, the Dow Jones and S&P 500 have reached new, all-time highs since the November election.

On the other hand, Europe continues to be a very inexpensive alternative relative to U.S. markets.

Here’s a history of the two markets since 1987:

 

Source: Bloomberg, The MacBeth Group

Europe has lagged behind the best performing market, the U.S., as measured by the S&P 500. This is as a result of people continuing to buy U.S. stocks while avoiding European names.

Just for fun I threw out the “Europe is cheap” idea to a few professional investment types over coffee. Instantly they came up with a list of reasons why Europe is cheap and why it’s likely to stay cheap:

  • An election in France this year
  • An election in Germany this year
  • Brexit action likely to move ahead this month
  • Greece is a problem again
  • Unemployment is stubbornly high
  • Very little restructuring
  • Slow economic growth

I was a bit taken aback by how quickly they came up with their objections, and how strongly they felt. It shows that the consensus on Europe is still very negative. For most professional investors it doesn’t pay to get ahead of the crowd and venture where no one else is going.

Nevertheless, stock markets in Europe are very inexpensive compared to the U.S. and compared to Europe’s past. Here’s what it looks like using the same methodology (Shiller CAPE) as last week’s examination of the U.S. market:

Greater Europe brings greater opportunities

For this chart European stocks are those contained in the DataStream Total Market Non-Financials Europe index

Sources: BlackRock, Credit Suisse

It appears that Europe is the cheapest it has ever been, at least in the last 40 years, including the period during the global financial crisis.

It pays to ask why this is the case. One major problem keeping Europe cheap is the fact that earnings growth – as measured by earnings per share (EPS) in the chart below – has lagged.

 

Sources: Barclays Research, DataStream, IBES

European earnings growth from 1987 to 2009 tracked very closely with the U.S., but since then there’s been a growing divergence.

In spite of the consensus and the well-documented problems, Credit Suisse feels that it’s time to buy Europe.

From a January 31 2017 report by Andrew Garthwaite, Global Equity Strategist:

“Europe’s forward P/E is at a 19 percent discount to the U.S.”

“Earnings momentum is at a 5-year high. Expect 8.5% growth”

“ECB will remain dovish”

“Loan growth is rising”

Optimism around Europe is echoed by BlackRock’s Chief Investment Strategist Richard Turnill, saying “investors have become too skeptical on the region, while the risk priced into the upcoming German and French elections is overstated.” Turnill anticipates European equity earnings will improve considerably in 2017:

European equity earnings grow estimates, 2011-2017

Source: BlackRock

Christian Mueller-Glissmann of Goldman Sachs is also bullish on Europe as is Ben Carlson of Ritholtz Wealth Management. Carlson writes an excellent blog called A Wealth of Common Sense which is worth following.

These opinions paint a very positive outlook, given that expectations are so low and valuations are so cheap. My guess is that many investors who are currently avoiding Europe would be shocked to hear that EPS growth might be 8.5% in 2017. I get very interested when the consensus view appears to be missing a turning point in a market.

What could go wrong? Well, there’s a lot of potential uncertainty:

  • The euro could rise
  • Marine Le Pen could be elected in France
  • Anti-EU government could get elected in Germany
  • EU could break up
  • Brexit could get messy
  • Military conflict could erupt between NATO and Russia

With these risks in mind it’s important to note that investors should obtain their own investment advice before acting on these suggestions.

Regarding said risks, it’s noteworthy that investors effortlessly point them out, likely indicating a blind spot. This makes it probable that European stocks will surprise to the upside in coming years to eventually outperform the S&P500.

 

Hilliard MacBeth

 

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Hilliard, The MacBeth Group team and their clients may trade in securities mentioned in this blog.

 

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