Thursday, May 3, 2012

Contrarian Alert: Take A Look At European Stocks

Remember March of 2009?*

The world was an ugly place. The S&P 500 had retraced all of its gains achieved over the prior 12 years, and stood at levels not seen since 1997

Each day the market seemed to be cascading lower; the S&P lost -12% during the first quarter of 2009.

And the price/book of the stocks in the S&P stood at multi-generational lows.

It was hard to find anyone bullish on stocks in 2009.  Instead, books were being published celebrating the sagacity of hedge funds managers who had made billions of dollars betting against the U.S. housing market.

So now, three years later, the S&P has doubled in value since the March 2009 lows, trouncing the returns of both gold and bonds.

What happened?

Lots of events, but most of them emanating from Washington.  The Fed flooded the system with liquidity, and backstopped all bank deposits.  Financial Armageddon was averted.

The fiscal side of the house did its part, too, with a massive stimulus package of nearly $1 trillion.

And I would argue one other event was occurring that was largely obscured at the time.

Corporate America was getting its house in order.  Although profit margins were already at healthy levels, corporations used a combination of technology and cost reductions (i.e., layoffs) to maintain profitability even if sales growth was sluggish or declining.

So when the government's stimulus efforts worked, corporate profits rebounded sharply, and stock prices climbed accordingly.

Why am I going through all of this recent history?

I believe we may be setting up for another opportunity, but this time in Europe.

Oh, I know what you're thinking: Doesn't Glen read the papers?

Civil unrest is rampant across the European continent as unemployment reaches record levels.  Governments from the Netherlands, Italy and, this weekend, probably France are being turned out of office by frustrated voters.  The euro zone is being held together by a massive liquidity infusion by the European Central Bank.

Yet Germany - the key player in the euro zone - continues to insist on more austerity measures.

Here's where the Cyrano Effect comes in.

Analyst Laszlo Birinyi first came up with this term.  When problems are as obvious as the nose on your face, Mr. Birinyi noted, they are most likely already reflected in stock prices.

So it is in Europe today, I believe.

According to Kevin Gardiner, head of European Investment strategy at Barclays, the stocks in most European markets are trading at 10 year lows, using price/book as valuation.

But here's the thing:  Earnings estimates for European companies are going higher, not lower.

Isn't this what investors should be looking for?:

Rising earnings estimates + cheap valuation = Opportunity

In addition, I have a feeling that the austerity regime in Europe will be moderating in the next few months.

It's no fun being head of a country when people are rioting outside of your office, demanding action to reduce unemployment and spur economic growth.

In other words, I see several similarities between the U.S. in 2009 and Europe in 2012:

  • Lots of central bank intervention - check.
  • Corporate balance sheets improving, and cost cutting implemented - check.
  • Fiscal stimulus - not yet, but probably coming.
  • Widespread pessimism - check.

I'm not saying the markets will move sharply higher in Europe, but I suspect they may be due for a fairly significant move higher in the next few months.

Sentiment is so negative that any good news is dismissed - the classic sign of capitulation that investors with a long term time horizon should welcome.

Just think back to how you felt in 2009 - and what the markets subsequently did.

*Of course you do, and so does most of the adult population of the U.S. That's why outflows from domestic equity mutual funds were the highest in 16 years in the month of April, according to Merrill Lynch.