In 2017, investors were largely focused on FANG stocks. Facebook, Apple, Amazon, Netflix and Alphabet (parent of Google) were the subject of countless stories and as a group delivered excellent performance. But, that was last year.
As investors know, they need to always be looking for next year’s winners. This year, that search may take them away from the shores of the United States. They may find more luck looking at Europe where many Wall Street analysts are looking for better returns.
Russell Investments is typical of the analysts highlighting European stocks in their year ahead forecasts. Analysts with the firm told investors in their opening sentences to look for “Better returns in Europe and Japan, relative to a lackluster U.S. equity market.”
Eurozone Offers Value
Most Wall Street forms, if not all, noted that US equities are overvalued in their annual forecasts. This is the consensus no matter how value is measured. However, that is not true all around the world.
When comparing value among different countries, the price to sales (P/S) ratio could be the fundamental metric that offers the best view. That is because earnings are governed by accounting rules and those rules differ among some countries.
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Differing rules make the price to earnings (P/E) ratio subject to variation among different countries. The same is true of the popular long term valuation tool known as CAPE or the cyclically adjusted price to earnings ratio. Both of these indicators could be applied with more confidence within one country.
The chart below shows the P/S ratio of different markets around the world. It is a heat map with grey and blue shading indicating low values of the P/S ratio and red indicating high values. Low values are generally considered more attractive to many investors.
Source: Star Capital
The map shows value in Europe, Russia, China and several other locations. Europe is, in general, the most stable of the regions highlighted as offering value.
Economic Growth Also Looks Bullish
Analysts at Lazard Asset Management noted that, “Euro zone economic growth continues to push ahead convincingly, and there is scope for more positive surprises in 2018.” The economy has been expanding since 2013.
Source: Russell Investments
Lazard added, “The euro zone’s economy has now expanded for 17 consecutive quarters and 2017 was its best year since 2010. Many leading indicators—including car sales, building permit data for residential and non-residential buildings, and private sector credit growth—continue to improve.
The positive momentum in economic indicators has dampened initial concerns about the European Central Bank (ECB) reducing its monthly asset purchases, as confidence in the euro zone’s economic recovery has taken root and the belief that the euro area is able to withstand a gradual withdrawal of stimulus has grown.”
Like the Federal Reserve in the United States, the ECB has been pursuing quantitative easing policies for some time. The ECB is set to start tapering its quantitative easing program in January 2018 but its balance sheet will continue to expand for much of this year.
The ECB will pare back its purchases, but monthly purchases of bonds should total €30 billion through September. The Fed has already stopped buying bonds and is actively reducing the size of its balance sheet through sales of bonds.
The Fed is also raising rates. The ECB, on the other hand, has assured investors that it will maintain interest rates at current levels and will retain the flexibility to reinvest maturing debt until at least 2019.
For now, analysts are expecting companies to report earnings growth of about 10% but tax reform could boost earnings even more.
Analysts have noted that plans are in place for France’s corporate tax rate to be cut to 25% over the next few years, while Italy and Switzerland are also considering reforms to their corporate tax regimes.
The United Kingdom also recently announced plans to cut the corporate tax rate to 17% by 2020 as countries attempt to boost their relative competitiveness and show companies they are open for business. Recent corporate tax cuts in the US could accelerate this trend.
Technicals Point to Significant Potential in European Markets
For US investors, the easiest and least expensive way to invest in European markets could be through exchange traded funds or ETFs. ETFs are low cost baskets of stocks that are traded on exchanges and carry low commissions just as stocks do.
Technical analysts can use charts to develop price targets for ETFs. One technique for doing this is with point and figure (P&F) charts. In a P&F chart, traders use columns of Xs and Os to show the price action. P&F charts ignore small price changes and filter out the noise of the market to highlight the trend.
Price targets can also be developed from P&F charts. The specifics are not covered here but will be the subject of another blog article. This technique has been applied to the chart of iShares MSCI Italy Capped ETF (NYSE: EWI) that is shown below.
The price target for EWI based on the P&F technique is $54.50. This is about 70% above the current price of the ETF. Fundamentals indicate this is a reasonable target. The P/S ratio is 0.9. For comparison, the P/S ratio of the S&P 500 is 2.3.
The next chart shows iShares MSCI Germany ETF (NYSE: EWG). The price target of $58 is more than 55% above the current price.
Fundamentals again support the price target. The P/S ratio of the stocks in EWG is 1.0.
Price targets based on P&F charts for iShares MSCI France ETF (NYSE: EWQ) and iShares MSCI United Kingdom ETF (NYSE: EWU) are also at least 40% above their current prices. Both ETFs also have P/S ratios that are significantly lower than the P/S ratio of the S&P 500.
There are risks in Europe just like there are in the US. However, prices of US stock market indexes are all trading well above their P&F price targets. This indicates the US is less attractive on a technical basis. Lower fundamental ratios indicate there could be less risk in Europe.
Overall, the risk to reward ratios appear more favorable in European indexes than in US indexes.
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