Some thoughts on relative value in the US and Europe

Despite the crisis in Greece, I have been talking about rotating into Europe because I believe equities are priced more reasonably than the US and because fixed income assets will get a boost from QE. I want to talk a bit more about this and about tech valuations, based on some interesting things David Rosenberg and Mark Cuban are saying. What I want to say here is more about high US valuations than relatively better European ones.

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Despite the crisis in Greece, I have been talking about rotating into Europe because I believe equities are priced more reasonably than the US and because fixed income assets will get a boost from QE. I want to talk a bit more about this and about tech valuations, based on some interesting things David Rosenberg and Mark Cuban are saying. What I want to say here is more about high US valuations than relatively better European ones.

Here’s what I am saying: “I am positive about European assets on a cyclical basis. European shares are cheaper than their American counterparts and European QE provides an underpinning for European sovereign debt. As long as Europe continues to muddle through, markets will continue to stay elevated. The biggest near- and medium-term risk remains Greece. If Greece blows up, the market and real economy impact will be bigger than many anticipate. That would be a major policy error, frankly. And we can’t dismiss this given how close Greece is to default right now. But if I had to own assets, I would want to own Australian and New Zealand government bonds, Spanish and Irish corporate bonds and non-Greece periphery equities over, say, US or German counterparts. Unfortunately, I can’t speak to Asia.

First, let’s look at what David Rosenberg is saying about the US and Europe. 

In the U.S., the market overall is definitely richly priced with a 17x forward price-to-earnings multiple, but the sectors that offer the most upside are those that are not hit by the negative earnings impact from the strong greenback and also have earnings visibility at a time when the analysts are taking a knife to their earnings forecasts. Those sectors would be technology, health care and, to a lesser extent, consumer cyclicals.

In terms of regions, parts of Asia and the euro area look quite compelling right now.

There are better valuations in many markets abroad and the difference between those regions and the U.S. — beyond lower price-earnings multiples — is that they are still receiving doses of monetary stimulus and benefiting from the tailwind of much more competitive currencies.

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That’s Rosenberg in the National Post. And I largely agree with this view. If you look at the US, I would say we are closer to the end of the economic cycle than the beginning. But of course, 2014 was the break out year for the US in many ways. For the first time in a generation, unemployment fell in every single state of the union. I think that’s remarkable and it could mean this economic cycle has legs. So I am willing to believe it can continue despite my belief we are nearer the end of cycle.

What concerns me regarding US valuations is two-fold. First, there is the lack of top-line growth that is masked by massive stock buybacks. The S&P 500 sales growth rate was only 3.54% through September 2014, the last date for which I have numbers. And this kind of anemic sales growth makes sense given the decline in nominal GDP. Everything else equal, you would expect that to translate into a sub-par earnings growth outlook. But because of share buybacks and operating leverage, we saw much higher earnings growth of 12.28% for the same one-year period to September 2014.

Operating leverage and share buybacks are double edged swords, however. On the way up, they boost EPS but when the cycle turns down and firms must husband cash and stop buying back shares, you get a double whammy as both the operating leverage and lack of EPS boost from buybacks crush earnings. So it all depends on where you are in the cycle. Right now, earnings growth is decelerating sharply. Last month, Factset’s John Butters wrote that:

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“On September 30, the estimated earnings growth rate for Q1 2015 was 9.9%. By December 31, the estimated growth rate had declined to 4.2%. Today, it stands at -1.6%.”

This would break eight consecutive quarters of year-over-year earnings growth. And 2015 consensus earnings growth for 2015 is now just 3%, more in line with sales growth. To my mind, this does not support the rich P/E multiple we see in the US. It also could mean we are very late cycle, where buybacks and operating leverage work against EPS growth.

Second, profit margins are high by historical standards. Ed Yardeni’s latest research piece gives you the historical context.

profit-margin-current-production.png

If you strip out the financials, profit margins look fairly normal. But when you look at all corporations, they are high. And financial services companies report accounting gains in a very pro-cyclical way. The closer we are to the end of the cycle, the greater the likelihood of a sharp mean reversion in margins both due to operating leverage and due to fictitious accounting gains in the financial services sector. If the Fed doesn’t make a policy error and the economic cycle rolls on, valuations can and will go higher. But valuations are looking stretched to me.

Then there’s Mark Cuban’s commentary at Blog Maverick. He says that the tech bubble this go round is worse than in 2000. Here’s his reasoning:

In a bubble there is always someone with a “great” idea pitching an investor the dream of a billion dollar payout with a comparison to an existing success story.  In the tech bubble it was Broadcast.com, AOL, Netscape, etc.  Today its, Uber, Twitter, Facebook, etc.

To the investor, its the hope of a huge payout.  But there is one critical difference.  Back then the companies  the general public was investing in were public companies. They may have been horrible companies, but being public meant that investors had liquidity to sell their stocks.

The bubble today comes from private investors who are investing in apps and small tech companies.

[…]

According to some data I found, there are 225k Angels in the US. Like the crazy days of the internet boom,  I wonder how many realize what they have gotten into ?

But they are not alone.

For those who can’t figure out how to be Angels. You can sign up to be part of the new excitement called Equity Crowd Funding. Equity Crowd Funding allows you to join the masses to chase investments with as little as 5k dollars.  Oh the possibilities !!

I have absolutely not doubt in my mind that most of these individual Angels and crowd funders are currently under water in their investments. Absolutely none. I say most. The percentage could be higher

Why ?

Because there is ZERO liquidity for any of those investments. None. Zero. Zip.  

I highly recommend you read Cuban’s post in its entirety. I think the Fed is aware that valuations are stretched and that there are patches of bubbles spurting up. They are concerned but not overly so because the real economy has not been firing on all cylinders. Nevertheless, the Fed is reactive. And to the degree they do feel uncomfortable about all of this, we should expect it to influence the pace of rate hikes this year.

As I write this post, Mario Draghi is telling the world that the ECB will launch quantitative easing on March 9th. I think this will put a backstop behind periphery sovereign debt outside of Greece. At the same time, I also believe the eurozone economy is getting better, and this is especially so in Spain and Ireland, which are benefitting from a rise in asset values that is helping credit growth. I expect European assets to do well against this backdrop, with the Greek situation as the big caveat. I would much rather be overweight Europe at this juncture than the US.

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