Declining Appeal Of The U.S. Stock Market

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Includes: DIA, FEZ, HEDJ, QQQ, SPY, VGK
by: Aloha Insight
Summary

Both the U.S. and European markets trade at high valuation multiples.

Cyclical outlook may favor European equities, but in the U.S. we find less structural issues.

Profit improvement potential should be much higher in Europe.

MSCI USA now trades with PE at 17.5. European stocks trade with PE at 15.7 (MSCI EMU). Both figures are rather high compared to historical standards, but I do not believe it is appropriate to talk about bubbles (see my previous post). Today I would like to focus on relative attractiveness of those two markets: Should global investors focus more on European, or American stocks?

First of all I would like to point out that there are sound arguments for international diversification and also against attempts to time the markets. From this perspective it is not very helpful to try to predict changes in relative attractiveness of the major global markets - they should all be part of a diversified portfolio no matter what the short-term outlook looks like. Nevertheless, despite this argument I believe it may be helpful to spend some time looking at both markets as suggested above.

If we look at the developments in recent years, we can easily conclude there are few major factors which seem to drive relative performance of the US and European equities. The former usually perform better when the monetary base growth in the US is stronger than in the eurozone. The same holds for GDP growth gap - the stronger the economic activity in the US, the stronger the relative performance of American equities. We can also add dollar/euro exchange rate: The stronger the dollar, the better the performance of European equities.

Now, if we believe the growth gap between the US and European economy will gradually diminish, the ECB will continue with quantitative easing while the Fed gradually tightens, and the dollar will keep appreciating, we should clearly favor European equities. As an additional argument in favor of European equities, we could add falling oil price. While it clearly had a negative effect on the US equities (and surprisingly weak positive effect on the American economy), it seems to have rather a strong positive influence on consumption and wider economic activity in eurozone. Moreover, as recently pointed out by Natixis, Japanese investors seem to buy more European equities now as they diversify their international portfolios.

Therefore, the case seems to be clear. Nevertheless, we could certainly find arguments favoring the US markets. Perhaps most importantly, it is far from clear that the growth gap between the American and European economies will keep closing. And while it may be true in the short term, we should keep in mind we are comparing two monetary unions, one of them functioning quite well, the other having quite serious design flaws. Greece is only the tip of an iceberg and I actually believe the long-term prospects of the eurozone will not improve significantly, unless some kind of wide scale debt restructuring takes place. Moreover, I would argue that most of the above arguments in favor of European markets should already be reflected in the market prices on both sides of the Atlantic. Therefore, only new information and surprises regarding growth gap, growth of the monetary base and overall monetary policy will shift the perceived attractiveness of both markets.

So are we back at the beginning? Maybe not. My guess is European equities could really perform better for some time and the reason is quite simple: Earnings and dividends. From the following two charts we can see earnings per share and dividends in the US are well above previous peaks, while in Europe they are still depressed:

Therefore, in the US we find stretched PE and stretched E, while in Europe only PE is high, while earnings are quite low relative to historical standards. If we assume the European economy and corporate sector are able to reach previous levels of activity and profitability, the case should really be clear. By the way, a similar line of argument holds for EM markets.

Disclaimer: I encourage you to do your own research and analysis. I use information obtained from sources I believe to be reliable, but its accuracy and completeness are not guaranteed. Any examples shown here are for demonstrational purposes only. My articles are in no way a recommendation to buy or sell any asset. They are my personal opinion, I am happy if they can help you make your own.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.