Wednesday, August 8, 2012

European Markets Continue to Climb the Wall of Worry

For most of this year I have tried to convince clients and colleagues that European stocks represented an enormous opportunity.

For example, here's what I wrote on May 18, 2012:

The more conditions worsen, and the more civil unrest occurs, the greater the pressure will be on the leaders to inject massive amounts of monetary and fiscal stimulus into the euro block to try to at least ameliorate the situation.

If this occurs, markets should rebound massively.  One only has to consider the large equity rallies that occurred in this country when the Fed intervened twice in the credit markets to see the potential.

The selling in European markets has been broad-based, and markets are priced at historically low valuations.  In Spain and France, for example, bank stocks have actually outperformed traditionally stodgy utility stocks, even though most would probably agree that the financial sector should be more at risk.  Investors just want out.

So here's how it could work out:  faced with a very unhappy populace, European leaders huddle and agree to try stop the economic hemorrhaging through a program of bank recapitalization, fiscal stimulus, and aggressive intervention in the credit markets.  Stock markets soar across Europe, and bond yields plummet, as bearish investors scramble to undo their bearish trades.

So what has happened?  Here's an excerpt from an Bloomberg piece this AM (I have added the emphasis):
The Stoxx Europe 600 Index (SXXP) slipped 0.4 percent to 267.66 at 10:33 a.m. in London, after climbing to the highest level since March 20 yesterday. The benchmark measure has rallied 14 percent since June 4, racking up nine straight weeks of gains, as policy makers eased repayment terms for Spanish lenders and optimism grew that central banks will announce more stimulus measures.

Even after the rally, European stocks do not seem expensive, and may yet represent an opportunity.  Here's what the Financial Times wrote yesterday:

...Even after the rally, European equities do not look expensive at 10 times earnings, 25 per cent below the long-term average.  Forecasts may still be optimistic, but are investors sufficiently primed for further downgrades?

A sanguine response to poor second-quarter numbers would suggest some disappointment is already priced in.  Investors have continues to reward beats, with European stocks outperforming the wider market by about 2.5 per cent after better than expected earnings, Morgan Stanley data show. But, so long as a company misses estimates by less than 5 per cent, its shares will still outperform the market, the broker says.

Combining low valuations and huge bearish sentiment has historically meant opportunities for huge gains in any equity markets.  Conditions in Europe remain ripe for further upside.