With the S&P 500 already up 26% from a low point in late October, money is starting to pour into European stocks. Investors should expect that to continue.
The
S&P 500
has become expensive, while the
Stoxx Europe 600
hasn’t. The S&P 500 is now trading at 20.7 times the per-share earnings its component companies are expected to bring in over the coming 12 months, up from just over 17 times at the start of the rally that began in October.
Forecasts for earnings estimates haven’t changed much. The gains have been driven instead by expectations that the economy will continue to grow, which would bring higher corporate profits as well. Investors are betting the Federal Reserve will succeed in beating inflation without steering the economy into a recession, and can soon begin to lower interest rates.
The problem is that current equity valuations are probably just too expensive, given that the 11 rate increases the Fed has rolled out since March 2022 make bonds a far more appealing investment than they were a few years ago. The yield on 10-year Treasury debt is now about 4.29%, while the earnings S&P 500 companies are expected to generate over the coming year amount to about 4.8% of the price of the index.
That isn’t even a full percentage point better than the yield on ultrasafe Treasury notes, so taking the risk of owning U.S. stocks has become less appealing. Money managers are responding with a move into international markets.
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On average, fund managers boosted the share of their portfolios devoted to stocks in the euro zone by more in March, relative to February, than for any other asset class in the world, according to a Bank of America survey. The largest reduction in allocations was in U.S. stocks.
And the shift likely isn’t over. The share of money managers who say their funds are overweight euro zone stocks remains near historic lows.
Putting a bigger share of assets into European stocks makes sense because they are trading at one of the widest discounts to the U.S. in a long time. The Stoxx Europe 600 trades at 13.8 times forward earnings, an unusually large 33% discount to the S&P 500, according to FactSet.
Even in August 2020, when technology stocks were pushing the S&P 500 ever higher and investors were avoiding more economically sensitive names, such as those that comprise most of the European index, the Stoxx Europe 600’s discount to the S&P 500 was only 20%.
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And the earnings yield on the Stoxx Europe 600 is far better than for the S&P 500. The profits expected for the coming year amount to 7.2% of the European index’s price, which is far better than the yield on U.S. bonds, better than the 4.1% on British 10-year debt, and way above the just over 2% on 10-year German debt.
Money should flow into the European market as long as economic developments in Europe unfold as expected. Economists are forecasting real growth in the low single digits for Germany, the U.K., Italy, and France for the next couple of years, according to FactSet. If inflation continues to moderate, as expected, the European Central Bank would be able to cut interest rates, keeping money flowing through the economy and allowing companies’ sales and profits to grow.
It’s a positive picture for European shares relative to the U.S.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com