The Long Case To Buy Old Europe ETFs

by: DoctoRx

Introduction: Recently, I wrote a Seeking Alpha article Why My Money Went To Spain Today. This involved my having bought into the iShares MSCI Spain Capped Index ETF (NYSEARCA:EWP).

I've been encouraged enough by the fundamental and technical action of this fund and of "Old Europe" in general to dip a couple more toes in the water in related European ETFs. This article discusses this thinking with a broader focus that the prior article did, and brings in more recent data.

The investment thesis here is that following a period of extreme economic pressure, several European economies have come through trial by fire, as it were. Further, the investment thesis is that their economies have begun to either rebound or else show positive second derivative action, just as the U.S. economy showed when its stock market bottomed three months before the recession ended. In any case, various "Old Europe" large-cap ETFs now show positive divergence to the continued negative headlines about their economies we usually see here in the U.S. Given the maturity of the U.S. economic cycle and high valuations, the thesis here is that U.S. investors may want to diversify into laggard stock markets that, until the 2009-11 period, had a high degree of correlation with U.S. markets.

Let's take an investment trip eastward to Europe.

Background: The largest economic bloc in the world, the European Union consists of the eurozone and EU member states that retain their own currencies. During the decade of the '00s, a number of southern-tier states experienced rapid wage growth and debt-financed expansion. Talk of the "Spanish miracle" was widespread, for example.

Following the unfortunate and often-tragic busts that followed, these countries had no opportunity to resolve their economic problems by using the expedient of currency devaluation. Thus, Spain and Italy have undergone, and are undergoing, lengthy internal deflation and shedding of excess, uncompetitive economic capacity. Alleged cases of political corruption have come to light. France is in a different situation, but has also had difficult economic circumstances and lots of bad publicity relating to actions taken by its Socialist government. Great Britain is several years into semi-austerity taken by a Conservative government, and has also engaged in modest currency depreciation and a huge program of central bank bond-buying, aka quantitative easing.

All the above countries now show at least some degree of either upward economic momentum (or diminishing downward momentum as often marks the bottom in stock prices) along with promising charts of relevant ETFs. I'll discuss several markets one by one.

Spain. The news could hardly have been worse recently. Years of depression. Vast quantities of unoccupied or unfinished homes. Allegations of political corruption both at the local and national level. Creation of a "bad bank" or two. To mention Spain economically now brings forth scorn, as shown by the comments above. Yet both Spain and EWP may be turning a corner. Here is the Yahoo! Finance chart of EWP vs. the leading ETF that tracks the S&P 500, the SPDR S&P 500 ETF (NYSEARCA:SPY):

Chart foriShares MSCI Spain Capped Index

Interesting. EWP outperformed in the boom years before the Global Financial Crisis. Now it has underperformed. The chatter in the news is at variance with the hopeful/improving economic trends, several of which were discussed in the above-linked article of mine. One now sees this sort of negative headline in a Spanish newspaper (Google Translate):

Niño Becerra: "Spain carries a debt you can not pay"

Well, maybe. But Spain has access to a printing press controlled by the European Central Bank, so I wouldn't be too quick to agree with Senor Becerra even if Spain's recession/depression is yet to end. I continue to wonder if as was the case in the U.S. as the Great Recession was winding down, perhaps the negativity is just a bit late.

Also, the International Monetary Fund issued a press release August 2 regarding Spain that had a very different tone, to wit:

Key imbalances are correcting rapidly. Sovereign yields fell sharply since the European Central Bank's announcements about Outright Monetary Transactions (OMT), the current account swung into surplus, the fiscal deficit fell sharply in 2012 despite the recession, private sector debt declined, and the banking system is stronger.

The reform process has accelerated and deepened. Decisive reforms in the labor, financial, and fiscal sectors, in line with past staff recommendations, is (are: ed.) helping stabilize the economy...

Fiscal frameworks and transparency have been substantially upgraded...

On labor market policy, a major reform was instituted in July 2012 to improve firms' ability to adjust working conditions (including wages)...

Product and service market reforms are underway. The government liberalized the establishment of small retail stores and retail business hours. Further reforms have been announced to remove regulations that fragment the domestic market, to liberalize professional services, and to foster entrepreneurship...

This is encouraging language.

Economically, Markit reported trends often seen at the bottom of an economic cycle on August 1 in its monthly manufacturing PMI report.

Increased new order flow and decreased input costs were seen, including labor shedding. That's just what was seen in the U.S. with the "green shoots" in 2009.

In addition to the long-term comparison chart of EWP with SPY, it may be surprising to see that EWP has outperformed SPY on two different time frames (though not all), both one year and one month:

Chart foriShares MSCI Spain Capped Index

Chart foriShares MSCI Spain Capped Index

EWP's fundamentals are discussed at the sponsor's website.

Italy: Italy's membership in the eurozone has precluded its historical reliance on currency devaluation to deal with over-indebtedness and a weak economy. Its mettle is being sorely tested, in part because Italy has the third largest national governmental debt in the world. However, its citizens are said to have squirreled away large amounts of wealth and carry relatively little debt. This may provide fuel for economic comeback. In any case, Italy may be turning a corner economically after suffering its fourth identified recession since 2000.

Markit had this to say about Italy in its August 1 manufacturing PMI:

Key points:

  • Headline PMI above 50.0 threshold as output and new orders rise
  • Sharpest increase in new export orders since April 2011
  • Input and output prices fall...

The associated multi-year chart of the PMI shows a strong acceleration upward.

Retail sales in Italy continue to fall, also per Markit's July report. The retail PMI was down to a weak 38.2. That chart shows an irregular uptrend that began when that index fell to about 29 around the end of 2011. An investor in EWI would be playing for a bottoming process in that sector.

Investors in the iShares MSCI Italy Capped Index (NYSEARCA:EWI) also have done surprisingly well versus the SPY over the past year:

Chart foriShares MSCI Italy Capped Index

Quiet outperformance when the economic data begins to turn upward may be a sign of yet better news to come.

The political turmoil in Italy might presage change for the better.

The very strong showing of a new, insurgent reform party, the Five Star Movement, in this year's national elections shows that many Italians truly are fed up with the status quo. Perhaps things can actually turn rosier for Italy.

France: France is one of the leaders of the EU and the eurozone. It has extraordinarily low national borrowing costs. Its banks are highly leveraged, however. Dexia, a Franco-Belgian bank, was bailed out in 2008 and is being restructured following the current European financial crisis. France has received heavy criticism for such matters as the imposition of high taxes, the governmental bailout of the auto company PSA Peugeot Citroen, and other matters. More embarrassment has come when the head of its budget, Jerome Cahuzac, tasked inter alia with cracking down on tax evasion, resigned this spring after being caught concealing a large Swiss bank account.

Yet here is the one-year chart of the iShares MSCI France Index Fund vs. the SPY:

Chart foriShares MSCI France Index (<a href=

The stock market is again telling a different story from the headlines. Maybe the stock market and economy in France will do what they did decades ago, when the Socialist Francois Mitterand took over the reins of government, business and the stock market got scared-- and then things went pretty well in their markets as the French worked matters out.

Longer term, we again see the "it's all one market theme" when looking at the EWQ and the SPY together from the late 1990s:

Chart foriShares MSCI France Index

I am playing for these two lines to draw closer again by going long EWQ.

The news from France via Markit also has turned encouraging. Per the August 1 PMI, output and new orders rose and input costs dropped.

U.K.: The British economy shows multiple signs of rebounding. The August 1 Markit PMI for the country's manufacturing sector was described in buoyant, almost exultant tones:

Growth of UK manufacturing production and new orders surges higher in July.

On August 2, Markit then released a construction PMI for Britain, which continues the theme:

Strongest construction output growth since June 2010, led by surge in housing activity.

Because the iShares MSCI United Kingdom Index (NYSEARCA:EWU) and similar funds, is/are heavily weighted to multinationals, I found a fund that is more oriented to the domestic U.K. economy. This is the FirstTrust United Kingdom AlphaDEX (NASDAQ:FKU). It is lightly traded in the U.S., however. FKU has outperformed the SPY but not the Russell 2000 index over the past 12 months.

Of course, Britain lacks the serious scandalous governmental headlines of the three countries listed above which have helped to understandably scare investors from those countries. A speeding ticket scandal and one extramarital affair were all it took to destroy the career of a possible future prime minister in Britain. That's an order of magnitude less serious than what has been reported to have occurred in the political circles of the countries mentioned above.

So there's less disbelief in the prospects of the U.K. than in the other countries, and therefore less risk and - perhaps- proportionately less upside.

Greece: Finally, even Greece is showing some signs of life. Its latest Markit PMI was 47.0, up sharply from its early 2012 low around 37 and at a 43-month high. I pay attention to 43-month highs in despised asset classes.

Even little Greece, an economic bit player, has an ETF tradable in the U.S., the Global X FTSE Greece 20 ETF (NYSEARCA:GREK). Several of the leading stocks, including the dominant one in the ETF of Coca-Cola Hellenic Bottling Company (CCH), can be purchased directly in the U.S. Consistent with the lagging PMI, the chart of GREK is less robust than any of the others mentioned herein:

Chart forGlobal X FTSE Greece 20 ETF (<a href=

This is a relatively new fund. Amazingly, it has tracked the SPY since it was created in late 2011.

Any investment in Greek stocks would clearly be in the speculative range; one might say that it is in the highly speculative range. (How much less risky than Greece investing in the much larger Spanish economy may or may not be is up to each investor's decision.)

Discussion: Investment trends go in cycles. Perceptions change. Economic busts can lead to booms. Political scandals can lead to reforms. The reported relative austerity of the European Central Bank versus that of the Federal Reserve can reverse. The euro, which is well off its highs and has been predicted to disappear by a number of commentators, may not only survive but could appreciate versus the U.S. dollar. If so, all eurozone investments would passively benefit if all else remained equal.

One simply never knows.

Moving to the specific ETFs discussed above, this article cannot review the components in any detail. Anyone interested in acquiring shares will likely want to at least look at the leading members of the ETF before purchase. The Italian ETF, EWI, has a 20% or so weighting to the national oil company ENI SpA (NYSE:E). In view of recent weak results from many oil majors, both US-based and Europe-based, that might be a negative.

Most of the ETFs discussed above have heavy representation to financial companies, especially large banking organizations. These have varying degrees of distress. My take on them is that Mr. Market knows all this.

The general sense I have is that European stocks are trading cheaper than U.S. stocks. I proffer no specific data, though; interested parties may wish to evaluate this matter.

The improving Markit PMI trends cited above are especially meaningful to me because the same group of releases showed weakness in many other countries. These include several Asian and western hemisphere countries. This was summarized in the JPMorgan Global Manufacturing PMI as well as in numerous individual country PMI reports.

Note: During the final editing process, Markit came out with service industry PMIs for much of Europe, as well as other countries. The linked page allows you to get to all the relevant reports. The U.K. data showed strong improvement; the others discussed here also were improved over the prior month. (Greece was not reported on in this category, or at least if it was surveyed, those data were not released publicly.) The Eurozone Composite PMI provides an overview of France, Italy and Spain's country reports.

Upon seeing the above data this morning, I increased my exposure to the U.K. with the iShares MSCI United Kingdom Small-Cap ETF (BATS:EWUS). As is the case with FKU, it is very lightly traded in the U.S.

Risks: Even a diversified portfolio of stocks held within an ETF may carry a high degree of risk. Economic trends may change, both from internal problems that (re)surface or from exogenous events. When evaluating a European ETF, one of the several difficulties of doing so from the U.S. tends to be a lack of knowledge of the companies that do business in their home and nearby markets. Also, the summary average P/E and other valuation metrics that the sponsor provides are not always able to provide a sense of the P/E of each individual component relative to its financial strength, operating history, growth prospects, etc. One basically can often do little other than perhaps subtract out the price:sales and price:book of, say, Eni from EWI to get a sense of how Italian stocks are valued without the influence of a very large oil stock.

Summary: Europe may be coming out of its economic funk. From a depressed base, it may even be outperforming, on trend, a number of Asian and Western hemisphere countries. European stock markets may be sniffing out a durable "turn" and may have plenty of upside price action if that proves to be the case. The historically fairly close relationship between most of the ETFs' price charts and the SPY may realign. If so, relative performance would then favor the laggards. A U.S.-centric portfolio therefore could potentially improve alpha and lower beta by adding exposure to Europe.

While there is no way to know if any of the above hypotheses will prove valid, U.S. investors may at least wish to look into the possibility of diversifying their stock investments into Europe. ETFs, mutual funds or the like would likely be easier and less volatile than finding and researching individual names unless one had special experience or expertise there, well-known companies that trade regularly on U.S. exchanges excepted.

Disclosure: I am long EWI, EWP, EWQ, FKU, GREK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Nothing herein is investment advice. The article is commentary only. I am not an investment adviser. The positions I am long may be sold at any time.