In my year end summary, I mentioned the argument for moving assets into the German stock market. Although the market has experienced a tremendous rally since the beginning of the year, both fundamentals and technical indicate more potential on the upside.
It seems increasingly clear that whatever the outcome of the European debt crisis, it won't mean a massive collapse of the German economy. In fact, a good argument can be made that the impact on Germany will be far less than the impact of the 2008 crisis for the United States.
Here is an (incomplete) list of damage to the U.S. economy from the 2008 crisis- most of which the U.S. is still struggling with: Decimation of the housing market and related construction and real estate industries, massive damage to the net worth of millions of Americans whose main asset was their home, large declines in tax revenues combined with costs of stimulus to fuel increased public debt and deficit, large scale structural unemployment, massive contraction of the financial services industry and continued political stalemate over long-term issues of deficit reduction.
It is hard to see anything close to those conditions hitting the German economy. The indicated negative sentiment in the business sector may have in fact bottomed out. German debt remains AAA and the flight to quality around the world has benefited German government debt, pushing rates to extremely low levels.
Even in the worst scenario one could imagine, it is hard to conceive that the German economy would find itself in as poor a condition as the U.S. after the 2008 financial crisis. The German economy goes into the crisis on a stronger structural position, trade and budget balance, low unemployment, less need for massive entitlement reform, to name a few. The crisis is not directly centered on Germany. Although that doesn't mean Germany is fully shielded from the economic crisis. But German policy, however frustrating to the rest of Europe, is based on not dragging Germany into the position as sole creditor to the rest of Europe.
With some of the world's top export-oriented companies among its top public companies, it's hard not to see the German market as a bargain compared to the U.S. The best vehicle for most U.S. investors to participate in the German market is likely the iShares German ETF EWG. According to the iShares website, EWG trades at a P/E of 15.5 vs. 19 for the Russell 3000 U.S. total market.
The top holdings of EWG are listed here. The list includes top global companies, major exporters who compete with their U.S. counterparts around the world. I took some of the top holdings and compared their P/E's to comparable American companies:
BASF (BASFY.PK): 9 - Dow Chemical (DOW): l 13.7
Ford (F): 7.3 - Daimler Benz (DDAIF.PK): 9
A recent article on Marketwatch noted the following about Daimler Benz- the #5 holding in EWG- and the only one on the list that holds a higher P/E than the U.S. company on the comparison list above (Ford, although of course they are not truly direct competitors):
Mercedes is the premier global luxury automobile. And it is a fantastic way to get "backdoor" exposure to emerging markets. China is already the world's largest consumer of the high-end S-Class, and China accounted for 18 percent of all Mercedes cars sold this past quarter. In trucks, the numbers are even better. More than half of Daimler truck sales come from Asia and Latin America.
Daimler trades for just 0.33 times sales. The company also has $15.33 per share in cash; at the current stock price of $45, this means that a third of the company's value is just its cash sitting in the bank.
Long-term, the U.S. and German markets have moved in tandem with Germany, showing a slight outperformance. However, the correlation between the DAX and the S&P 500 has dropped considerably since the U.S. crisis of 2008.
As can be seen below, that crisis began a period of significant underperfomance for Germany vs. the U.S., reversing the pre-crisis pattern. This performance differential created the gaps in valuation noted above. Between January 2008 and the end of 2011, the total return in a comparison with EWG was -39.2% for EWG vs -5.6% for the SPY (S&P 500)
Although one should hesitate from drawing too large a conclusion from recent events, it is instructive to look at market behavior of late. Despite the intensification of the Greek and European debt crisis, German shares have experienced quite a rally of late. Since January 1, EWG is up 12.7%, the SPY is up +5%.
Although I would not call myself a market technician, I am quite familiar with technical analysis. Technical analysis was once dismissed as no more useful than astrology for analyzing financial markets by academic researchers, but it has gained more respect of late. Note, for instance, highly-respected MIT finance professor Andrew Lo's book, The Heretics of Finance. The other reason is that academics now acknowledge there is a momentum factor in markets. Although no one has found a foolproof way to capture that momentum factor, it is clear that the core of technical analysis is to identify the strength and direction of market momentum. The other reason I think, is that technical analysis fits in so well with behavioral finance; it is a picture of many of the behavioral tendencies that researchers in that area have found. The charts show where positions were accumulated and therefore indicates points at which selling or buying will likely increase.
Looking at the chart below of EWG, a technician would have to see a great deal of momentum building behind the upward price movement.
The chart shows that the price is approaching a large price "gap" right above $23. Technicians anticipate that most gaps are "filled". If one looks at the volume last November, the spike in volume that conincides with a large spike in volume indicates a large amount of buying in anticipation of a rally or in the form of short covering. Should the price action exceed that November low, it should spark a renewed momentum of buyers as well as in all likelihood, large scale covering of short positions.
Given the negativity towards Europe and Germany over the past 3 years or more, it is likely there are a considerable number of leveraged short positions on German indices and German stocks that would buy back the positions should Germany rally further.
Another widely used technical indicator, the 50 day moving average, was crossed around the beginning of the year (brown line in chart above), a bullish indicator. The 200 day moving average (not shown) is also widely used and an indicator of longer term trends. It is currently a bit over $22, which from a technician's view means EWG has significant upside potential.
In sum, macroeconomics, valuations and price action/technicals indicate that for many, the surprise equity market of 2012 may be Germany. The conventional wisdom going into 2012- to avoid Europe- may turn out to be as wrong as most beginning-of-the-year forecasts in past years.
Additional disclosure: Mr. Weinman's clients have positions in EWG