From the early May closing high to last Fridays close, the Euro Stoxx 50 Index is down -5.7%. While the most likely scenario for Euro Zone equities remains the drop and pop that we have become accustomed to with U.S. equities, we find several factors more than a bit concerning for Euro Zone equities.
Before explaining our concerns, we remind readers of the main reasons that we remain bullish on Euro Zone equities. Our positive outlook on European equities is essentially due to relative valuations versus the U.S. and to monetary policy lags at the European Central Bank versus the Federal Reserve. Indeed, relative valuations in the Euro Zone remain very attractive. European valuations remain lower than the U.S., despite the different composition of the U.S. stock market.
We looked as the price/earnings ratios (P/E) of European large capitalization firms versus U.S. large caps, comparing the historical 12-month trailing P/E ratio for the Euro Stoxx 50 index versusw shows the same metric for the S&P 100. Euro Zone equities are down to 19 times earnings (from 25x in 2014) while the S&P 100 has risen to nearly 21 times earnings (from 16x in 2014) !
The European market is now delivering a more supportive earnings revision trend. In addition, we are seeing margins beginning to improve on the back of a strong macro backdrop, improvement in pricing power, and a global capex spending recovery.
Even more impressive that the discrepancy in trailing 12-month P/Es is the divergence in the Shiller P/E. Recall that the Shiller, or cyclically-adjusted price-to-earnings ratio (CAPE), divides price by the average of 10-year earnings, adjusted for inflation. The chart of European versus U.S. Shiller P/Es speaks for itself. We have posted our 12-month trailing and Shiller P/E charts here.
It would almost seem to be a no-brainer for a long-term investor to over-weight European equities. Alas, in a market that has defied valuations and traditional investing logic for the greater part of this bull market, it is still the crowded/over-bought equity sectors with rich valuations that continue to outperform.
Before delving into our analysis, we remind readers that we are making a distinction between the Euro Zone and the U.K. within the European equity universe. U.K. equity valuations are much richer than Euro Zone equities, the currency dynamics of the euro and pound sterling are quite divergent due to Brexit, and political risks are now distinctly different between the two regions. In addition, the chart of the FTSE Index is holding up relatively well compared to that of the German DAX or French CAC40.
Which bring us to our first concern regarding Euro Zone equities. Chart technicals are souring rapidly. Looking first at the Euro Stoxx Index (comprising roughly 300 European large cap stocks), a down channel has been formed since May. As shown by the red hashes in the chart below, the index has put in three lower swing highs. A break below the late June low of 372, which would open up a lower low, can not be ignored by traders.
The German DAX has already formed a lower low
while the French CAC40 is in a textbook down-trend, with the index hitting repeatedly the upper and lower boundaries.
Besides the shorter-term technicals, as well as the current idiosyncrasy of this market that overvalued, crowded asset classes tend to rise the most, we have several most substantial worries that could transform the current downtrend in European indexes into a full-blown bear market.
Our #1 concern is euro strength in the coming months. It is not surprising that the DAX is leading European indexes lower, as German exporters weigh heavily in the index composition. The 30-year correlation coefficient between the DAX and the EUR/USD exchange rate is negative (-0.072, using weekly data). Given the positive momentum in EUR/USD and last weeks break-out to a new 14-month high, the odds are in favour of seeing the euro climb further this year --- which will not be pleasing to Euro Zone equity bulls.
We note in passing that the U.K. equities may be an exception to currency appreciation. While GBP/USD will likely rally with EUR/USD, the pound will remain attractive for U.K. companies even after a +10% move in the GBP/USD, given the depressed levels of sterling since Brexit.
Our second concern for Euro Zone equities involves the central banks. The European Central Bank (ECB) inflation target is 2%. The ECB, unlike the Fed, does not have a dual mandate to target employment (and loosely economic growth). Vigilant Bundesbank officials will see to it that Mario Draghi and Company dont let inflation run too far above this target. QE-forever wont fly in Euro Zone if inflation nudges higher.
Meanwhile, Janet Yellen and several Fed members have expressed willingness to let the economy run hot for a period. Concretely, the experimental-minded Fed members would accept a 3% to 4% annual inflation rate to see how the economy reacts. Of course, should the Fed decide not to take away the proverbial punchbowl, this could be extremely bullish for U.S. equities
and relatively detrimental to Euro Zone equities.
Another, more fundamental concern with the Euro Zone central bank, which limits the ability of the ECB governors to run wild with extraordinary monetary policy, is the diversity of European economies. The ECB is making monetary policy for 19 different countries 19 economies running at different speeds. While some commentators claim that a common European monetary policy and the ECB itself are doomed for failure (we wont go to that extreme), we will agree that fixing a monetary policy appropriate the median European economy (eg: Germany) leaves the door open for problems in the periphery. While extraordinary monetary policy may be appropriate in Greece, Spain and Italy, this is most certainly not the case for the Germany or Northern European economies.
A third fundamental concern, following up on this last point, is that the Euro Zone remains a tinderbox for political and monetary crises. Greece has been swept under the rug -- no solution, other than shuffling around bad debt, has been achieved in Greece. The PIIGS sovereign debt problems have been forgotten (the bull market obliges), but as soon as equities turn down more severely, well be hearing once again about Italys 150% debt-to-GDP ratio.
A final, near-term variable that worries us with the Euro Zone equity space is seasonality. In our recent Commentary, Statistical Odds of a Seasonal Equity Correction, we demonstrated that, while August/September has tended to be a challenging seasonal period for the S&P 500 in general, when the S&P 500 has a positive first half return, August/September tend to be anodyne. This is not true for the Euro Stoxx index. The first chart below shows the overall seasonal performance of the Euro Zone benchmark index since 1987. The average return in August and September has been -1.5% and -2.0%, respectively, while the percentage of times that these two months are positive is a bit worse than a coin toss.
Sorting the annual Euro Stoxx returns to include only years with a positive first half, we cant be as reassuring as with our S&P 500 study. Returns in August/September tend to be just as bad when the first half of the year is positive. As shown on the next chart, August has been a horrendous month after positive first halves. One possible explanation is that August tends to be sleepy time in Europe, when most senior managers leave for 3-week vacations. The lower trading volumes, with banks manned by junior traders, could very well explain the fragility in August.
Euro Zone equities may be at a tipping point. While valuations remain very compelling for longer-term investors, attractive stocks have been the losers in todays market, which rewards investors who crowd into over-valued names. Near-term prudence is advised for Euro Zone investors, at least until the current down-trend is broken.