Don't Rush To Buy European Equities - Wait For Further Fall In Forward P/E

by: William Arrata, CFA

It is common to hear that the current risk premium in European equities won't last. Sure, this level is justified by the current funding stress of Eurozone peripheral sovereigns. But after all, if one shares the view that Germany has more to lose than to win from a Eurozone break up, the ECB intervention to buy Eurozone peripheral sovereign debt is only a question of time. So why bother about the level reached by the ERP, when everyone knows that it will narrow sooner or later? Shouldn’t you rush to buy European equities at such a discount before everyone else does? Well, the preferred timing for the ECB to intervene might not come without a cost for future economic growth.

Some people reasonably think that the ECB will intervene only after sovereign debt market stress reaches a climax, to maximize its bargaining power with Eurozone peripheral sovereign issuers. That would allow the ECB to impose fiscal conditions against its interventions. In other words, the ECB would be in the strongest position to get what it wants from states only if they are on the verge of collapsing. But waiting for that moment might not leave Eurozone economies harmless in the meantime. Additional costs would probably have been incurred. More precisely, the later the ECB intervenes, the bigger those additional costs for the economy. Again, the ECB can win that "game" only if the funding situation of sovereign deteriorates sufficiently so that it can impose its conditions.

Sovereigns will be the first to incur those additional costs, but other economic agents as well. Corporates would thus be one of the collateral victims of this "game" played by the ECB with Eurozone peripheral sovereign states.

Sure, once the intervention happens, we expect the ERP to narrow. Would that mean that prices will go up significantly? Well, maybe not. In the meantime, investors might realize the inevitable costs of the ECB bargaining "game" for corporates. They might realize that growth is even lower than what they expected, and that growth prospects are even bleaker.

This is why equity investors should not rush on European equities. While the ERP will narrow sometime in the future, the later the ECB intervenes, the more expensive the growth expectations component of current prices will appear ex-post. In particular, an ECB intervention very late in 2012 might translate into much lower realized earnings growth, and much lower expected earnings growth.

The forward P/E of European equities might thus still be too high at the moment, and even if the risk premium is currently substantial, it might be worth waiting for a further fall in forward P/E to step in, when the earnings growth rate is revised downward by investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.