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European Stocks: Looking Good, As Long You’re Looking to Hold

Optimism is high, but so are the near-term risks


Suddenly, European stocks look hot again. Investors are feeling much better about the region now than they were a little over a year ago at this time, as the economy appears to be healing and the news flow has been free of nasty surprises.

In just the seven-day period from July 31 through Aug. 6, Vanguard FTSE Europe ETF (VGK) — the largest European stock ETF — raked in $521 billion in new assets, while iShares MSCI EMU ETF (EZU) attracted another $129 billion. This brings the year-to-date haul for the two funds to over $2 billion — indicating that investors continue to see better days ahead for the region.

But at this point, are European stocks still a buy?

Improving Growth Fuels Optimism

The crux of the positive case for European stocks is the improvement in its economy.

The region is expected to return to positive growth in the coming year, even in Italy, Spain and Portugal — the three countries that have been most troubled during the crisis. Consumer confidence and manufacturing are at their highest levels in two years, and — unlike the United States — central bank accommodation appears set to continue indefinitely.

Absolute growth is still meager at best: The IMF is forecasting a contraction of 0.6% in regional GDP in 2013, followed by growth of just 0.9% in 2014. But on a relative basis, this represents a substantial improvement from the six straight calendar quarters of negative growth in region is currently mired. Further, the rate of change is more impressive than investors are seeing from the United States, Japan or the emerging markets.

Another important reason why European stocks have attracted assets in recent weeks is that even though the news flow has been generally positive, market performance hasn’t followed suit, alerting investors to the pent-up value in the region. Year-to-date through Aug. 6, VGK had logged a gain of 9.8%, trailing both the SPDR S&P 500 ETF (SPY, +20.4%) and iShares MSCI Japan ETF (EWJ, +21%).

This performance gap extends over the longer-term time periods as well:

Index 1-Year 3-Year 5-Year 10-Year
MSCI Europe Index 20.68% 5.06% -2.25% 5.22%
MSCI Japan Index 31.15% 6.33% 0.51% 5.06%
MSCI USA Index 22.07% 14.99% 5.76% 5.96%

One result of this underperformance is that the region remains inexpensively valued relative to the rest of the world. According to Barron’s, the European markets are trading at 11.8 times 2014 earnings estimates, versus 13.7 for the S&P 500 and 16.3 for Japan’s Nikkei 225 Index. Notably, the European markets are still well beneath their pre-financial-crisis highs, whereas the U.S. market is in record territory.

Does This Mean It’s Time to Buy?

Europe appears to the most attractive of the three major regions on the basis of both economic expectations and valuations, and the region has plenty of potential for outperformance simply on the basis of mean reversion. For those investing over a longer-term time horizon, this signals a compelling opportunity.

In the near term, however, the buy case isn’t quite so clear-cut. Funds such as VGK or its mutual fund counterpart — Vanguard European Stock Index Fund (VEURX) — are indeed in a strong position to outperform, but only if the following conditions are fulfilled:

  1. The recent uptick in economic data continues with no sign of a reversal, or worse, fresh news related to the region’s debt crisis.
  2. China avoids the type of  “hard landing” that could derail earnings for the many multinational companies headquartered in Europe.
  3. The U.S. Federal Reserve manages to put its tapering policy into place without causing major market disruptions.

In all likelihood, one or more of these factors will lead to bumps in the road for European stocks in the coming 12 months.

Europe’s recovery is fragile, meaning that its market performance is as well. This was visible in the second-quarter downturn, during which Europe underperformed the United States by a wide margin. From May 22 through the June 24 low, SPY fell 4.9%, but this was outstripped by losses of 7.9% for VGK, 7.5% for EZU and 10.6% for WisdomTree Europe Hedged Equity Fund (HEDJ). This indicates that investor in European equities remain jittery despite the gradual improvement in economic data. As a result, the region’s markets are likely to exhibit underperformance if additional negative surprises crop up in the months ahead.

The bottom line: If you buy Europe right now, make sure it’s with an eye to the long-term potential of the region’s markets. With several risk factors still very much in play, a short-term trade here is little more than a coin flip.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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