Back in October of last year, we pointed to some counterintuitive positive catalysts for European stocks -- at the time, the only headlines concerning Europe were ominous, and it looked like a case of "cheap, but not cheap enough." The points we made were:
1. Favorable foreign exchange conditions could lead to a more positive picture for European companies than many are expecting;
2. European stocks are priced for [almost] the worst case scenario;
3. US companies could -- and probably should -- go on a European shopping spree, snapping up competition at rock-bottom prices;
4. Last is the most obvious, and most talked about, but also perhaps the most underestimated--stimulus.
Remember that the euro had already experienced a good deal of weakness against the U.S. dollar, prior to the recent and unprecedented action by the European Central Bank. And six months ago, while some measure of stimulus was expected from the ECB, it was priced into European stocks that said stimulus would end up being disappointing and downright ineffectual. It was far from obvious that ECB Chief Mario Draghi would get American-style quantitative easing past the goalie that was Angela Merkel.
But he did, and that has further weakened the euro, enhancing the foreign exchange advantage to European exporters. So let's look at some of last year's points and see how they fare today.
Are European stocks still priced for the worst case scenario?
Since the stimulus-inspired rally overseas started in January, we are now hearing from the financial media -- on a daily basis -- that Europe may be a good place to invest in 2015. In fact, we are already hearing questions about whether or not it's "too late to get involved in the trade." This argument does not take into account the whole picture.
Buying international stocks is not a trade, it's a part of a standard asset allocation for any fully constructed portfolio. It just so happens that it's the portion of your portfolio that has underperformed (the S&P 500, anyway) for the past six years.
Here is the Vanguard FTSE Europe ETF (VGK) over the past three months:
But go back 10 years, and you'll see we would need another 50% to test all-time highs.
The stocks making up the European benchmark index are dirt cheap relative to the S&P 500, though commentators would have you believe the recent 10% rally has them looking fully priced. After all, the P/E ratio is 16, which is not low by historical standards. Why is this not a concern?
a) Earnings have struggled in the eurozone for years, and for a multitude of reasons (not least of which was the lack of stimulus in a world filled with it -- they were competing on an uneven playing field). So the "P" being measured in P/E was reflecting a pre-stimulus "E." Consider that the P/E ratio for the S&P 500 spiked above 100 in January of 2009, as earnings temporarily vanished or went negative. Of course, we haven't seen prices (P) that low since. That was over 200% ago...
b) Interest rates in the eurozone are even lower than they are here. Now, that alone doesn't mean anything unless you are willing to make the assumption that the TINA (There Is No Alternative) argument is even more exacerbated in Europe than it has been in the United States for at least three years now. We'll call it TINAIEE -- There Is No Alternative in Europe Either.
American CEOs should go to Europe this summer
Americans looking into vacation options may be surprised at how affordable it's become to visit places like Paris or Rome. Our country's CEOs are likely feeling the exact same way today.
Over the past two years, CEOs of U.S.-based companies have certainly gotten creative in their quest for plumping up profitability in a low-growth economy. In 2013 the story was buying smaller foreign competitors to re-domicile internationally in the name of lower tax rates; in 2014, we saw companies issuing debt to facilitate enormous stock buybacks -- is 2015 the year when American companies go shopping for recognizable European conglomerates that are now 25% cheaper than they were a year ago due to dollar strength?
What a difference a year makes
On Wednesday we saw FedEx (FDX) take out Dutch delivery firm TNT Express (TNTEY) for $4.8 billion to expand operations into Europe. Today that amount represents just over 4.5 billion euros; one year ago $4.8 billion would have only bought a company worth 3.5 billion euros. Quite a difference.
Another example is General Electric (GE), in the final stages of closing its estimated $14 billion acquisition of France-based Alstom's energy assets -- a deal in which GE outbid Germany's Siemens. Today we learned that GE is divesting $30 billion worth of its GE Capital division's real estate. I wonder if Jeff Immelt has any plans for that cash...
Your money is no good here
And what if we saw U.S.-based companies tapping the European debt markets to finance such deals? Rates are zero, literally, so there would be no financing cost for a company with a strong balance sheet to buy its competition. That's like showing up uninvited to a dinner party, eating your fill, and then taking leftovers and the silverware with you.
Confidence around the eurozone is still tenuous at best, but U.S. corporate balance sheets are as healthy as they've ever been -- look for American CEOs to jump on this new opportunity to buy growth, and take advantage by getting long (or longer) European equities.