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September 8, 2013 2:18 pm
European stocks, this column has pointed out before, are not as cheap as they look. They have dipped in the past few years because of the sovereign debt crisis, but it is still reasonable to factor in a risk of more trouble to come from that quarter. And while European stocks look cheaper than US stocks, that is in large part because they always do: US indices are stuffed with high-technology companies that trade on expensive multiples, while European indices have a lot of dull dividend-paying utilities.
But there is still scope to argue for a European buying opportunity. What if European profits were to take off in short order? That hope is not as far-fetched as it sounds and has driven a flurry of interest in “long Europe”, as funds switch into EU equities at the urging of brokers.
We can construct such an argument first by looking at how European profits fare over the cycle. Over time, profits tend to revert to the mean, with each peak in the cycle higher than the one that preceded it. That is what happened in the US, where earnings were back above their 2007 peak by the end of 2011.
In Europe, the sovereign debt crisis interrupted the cycle. Following the sharp fall post-Lehman, European profits had barely made it back to their long-term mean in 2010 before subsiding once more.
In this respect, the difference with the US is marked. According to Andrew Lapthorne of Société Générale, US profits are now 25 per cent above their 10-year moving average, while European profits are some 10 per cent below their trend.
Now add valuation. US indices are always more expensive but, at present, the S&P500 trades at 0.7 times book value more than the FTSE-Eurofirst 300 – until the sovereign debt crisis broke out, this gap tended to be more like 0.5 times book.
And while brokers tend to dislike cyclically adjusted price/earnings (Cape) ratios (the subject of much debate in these pages recently), many happily cite them for European stocks, because they make Europe look very cheap. While the Cape suggests that the US is significantly more expensive than its long-term mean, it shows European stocks a full standard deviation below their mean – a level that has in the past been a reliable indicator of strong returns in the future.
Or try to put it together with some crude technical analysis. “Long US Short Europe” has been a spectacularly successful trade, but it now has the look of being overdone. Since the first dawnings of the credit crisis in early 2007, the S&P has beaten the FTSE-Eurofirst by 52 per cent. Even after the recent flurry of interest in Europe, US stocks have beaten their European equivalents by almost most 9 per cent for the year so far. It looks like a trend that is ready to reverse.
Those, then, are the arguments. But there is still a retort, which boils down in one word to “Japan”. European growth is stagnant, and much of the continent is mired in a serious recession. All of the arguments above rely on European profits perking up back to the mean. But in Japan, after its economy peaked in 1989, corporate earnings dipped and took 15 years to get back to their peak. Many times over the past two decades, investors have plunged into Japan on much the same investment case that is now being laid out for Europe, only to be disappointed.
This is a critical point, and Karen Olney at UBS garnered much attention last week with a five-point note on “Why Europe is not Japan”. First, she points out that Europe appears to be in little danger of slipping into deflation, as Japan did. On a continent-wide basis, it never suffered a remotely comparable property bubble (countries such as Spain are an exception). Corporate debt, at 40 per cent of equity, is far below the 123 per cent recorded by Japanese companies four years into their slump. Capital expenditures peaked at 22 per cent of gross domestic product ahead of the crisis – compared with 33 per cent in Japan in 1989 – so there is not the same legacy of over-investment. And Japan started wildly expensive, by any sensible measure. Europe did not.
Assuming that Europe does not fall into a Japanese-style morass, Ms Olney suggests that profit growth of 8 per cent per year for the next three years – not such a lot to ask – would be enough to bring Europe back to the peak profits implied by the usual cycle of mean reversion.
These are good arguments. On a relative basis, European stocks offer better value than the US. (There are exceptions, but this top-down picture is accurate).
But there remains a reason why Europe is cheap. Buying European stocks on anything other than a long-term basis still involves a bet that Europe’s politicians make the necessary institutional reforms to the EU without triggering another leg to the crisis. That is still not an obvious bet. If that bet comes off, however, Corporate Europe has a decent chance of staging a rebound in profitability.
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