Europe’s stock markets are relatively
cheap
Hilliard MacBeth
Hilliard’s Weekend Notebook – Friday, July 3, 2015
Richardson GMP
10180 101 Street, Suite 3360
Edmonton, AB T5J 3S4
The drama with Greece continues and won’t be resolved this weekend although we
don’t expect the European Union or the € to collapse. At the same time the US stock
market’s excellent performance in recent years obscures one important fact: most
stock markets in Europe are cheap compared to US markets. Is it time to buy?
Chart courtesy of BCA Research Inc.
Last week — see “Earnings matter” — I talked about how earnings are key to driving
stock market performance. But earnings, while very important, are not the whole
story. Investor expectations for short-term market gains and changes in direction in
economic growth are very important too.
For example, imagine an economic region that had suffered worse economic growth
in the last six years than during the period of 1929 to 1935. Hard to imagine?
That’s the case in Europe today.
In the 1930s, the European economy, led by frantic German investment in
armaments and the military, was 5% larger in 1935 compared to 1929 measured in
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Hilliard MacBeth
Director, Wealth Management
Portfolio Manager
Tel. 780.409.7740
real (adjusted for inflation) GDP. Today the Eurozone economy is 2% SMALLER
than in 2008.
As a result, based on expected reversion to the mean, the prospects for economic
growth are better for the next ten years in Europe than most other areas in the world.
And investors’ expectations are very modest.
In our investment strategy we like to find markets that are currently neglected or
overlooked by the all-important institutional investor crowd (pensions, mutual funds,
hedge funds etc.) that make up at least 80% of market activity. These hired
professional managers are forced by their supervisors and their investors to
concentrate on the three-month-to-one-year time horizon. They have no choice.
And these investors follow herd-like behavior, out of a strong desire to keep their
jobs.
So often there will an investment that is unpopular today with that crowd but in one
or two years that lack of attention will reverse and the attitude will shift 180 degrees.
This happens all the time in the stock market.
If Europe is neglected by the professional investor crowd, is in the middle of a crisis
due to the possible disintegration of the currency block, and has suffered negative
economic growth for the last six years and is cheaper than US markets by about
32% as measured by stock prices and earnings, it could be a good time to look for
bargains there.
Our strategy involves the basic idea that if a sector or a geographic region is
neglected by institutional investors, who control most of the money in the stock
market, then there must be more companies that can be purchased for a reasonable
price than shares of companies in a “hot” sector or region. This doesn’t apply to
every single company in the sector but it does apply on average.
The sectors in the stock market that are “cold” or overlooked or out-of-favour must
contain more bargains, assuming that the companies survive and the “cold” sector
or region eventually becomes attractive to investors again. Even if it takes a year or
two or three.
How much cheaper is the European stock market compared to the US stock
market? As measured by Robert Shiller’s CAPE (cyclically-adjusted price to
earnings ratio) the US market is more expensive, with the CAPE higher than 24,
one of the highest levels ever except for the dot-com bubble in 2000 (over 40) and
1929 (27.3).
Chart courtesy of BCA Research Inc.
Europe’s CAPE is less expensive at about 17 times. This looks like a 32% difference
although the argument can be made that the spread is about 15%, when adjusted
for the differences between the two markets. Even among the big three Germany,
France and Italy there is a wide range. Germany, the largest weighting, is about 18
times and Italy is 10.3 times.
So the conclusion is that it is time to buy Europe, especially if things get messy in
the next week because of Greece. With the caveat that individual sectors like IT
(more important in the US) and financials (heavier weight in Europe) vary in
importance between US and Eurozone markets, bargains are more prevalent in
Europe.