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Friday, July 25, 2014

European Stock Selloff: Noise and Opportunity…or Signal of Worse Times Ahead

European stocks have fallen sharply over the past month. Based on ETFs total returns between June 20 and July 22 the selloff looks like this:
FEZ (Eurozone) -4.5%
EWG (Germany) -3.7%
EWI (Italy) -6.1%
EWP (Spain) -5.3
Over the same period the S+P 500 is up 1.2%

When looking at short term moves of this magnitude it is useful to review the fundamentals and to judge whether a move of this type is “noise” a movement based on short term news but not something that changes the long term picture or a major signal. Markets overshoot and in my view it isn’t often that a large move like this is justified by fundamentals.
Bloomberg gives a good overview of what is going on in the European markets.
Sections in italics are quotations from the article

Germany was the first of the European stock markets to recover from the Euro crisis of 2011. German stocks sold off along with the rest of the Euro zone  during the crisis despite the fact that the largest German companies are world class multinationals( Siemens, BASF, Daimler Benz for example) and not dependent on the Euro zone for their success. The valuation discount of these stocks vs US competitors created an opportunity for investors and the German market recovered as price returned to value.
As Bloomberg notes:
The DAX (German Stock Index)rallied as investors sought safer stocks during the euro area’s sovereign-debt crisis and bet that Germany’s export-oriented companies would benefit from global growth. While the index surged more than 25 percent in each of the past two years, it’s gained only 1.9 percent in 2014, lagging behind the 10 percent jump for Italy’s FTSE MIB Index and the 7.4 percent increase in Spain’s IBEX 35 Index. (IBEX) The Stoxx Europe 600 Index has climbed 4.3 percent this year.
Not surprising there has been a bit of performance chasing as seen in ETF flows:
Traders have pulled almost $817 million in the past six weeks from a U.S. exchange-traded fund holding German companies, while investing $270 million in an ETF of broader European equities, according to data compiled by Bloomberg…. The number of shares outstanding on the Vanguard FTSE Europe ETF (VGK) climbed to arecord 289 million this month, while it fell to 161 million for the iShares MSCI Germany ETF, the least in more than a year, data compiled by Bloomberg show. Traders have pulled almost $1.2 billion from the German fund in 2014, after investing in it for the past five years, according to the data. They’ve added or kept money in the European ETF every week but two since April 2013
There is some logic to investors spreading their assets beyond Germany and elsewhere in Europe. The valuations are more compelling in Italy and Spain and the data particularly from Spain are more encouraging. Both the Italian and Spanish indices include world class multinationals not dependent solely on domestic markets. There is one crucial difference: financials have a significant weighting in the Italian and Spanish indices and there are concerns about financial stability. Nonetheless the aggressive low interest rate and other policies of the European Central Bank (ECB) stands behind those financial institutions.
As the Bloomberg article notes:
Even after this year’s advance, the Spanish equity gauge is 50 percent away from its 2007 peak, while the Italian measure and Portugal’s PSI 20 Index (PSI20) would each have to more than double to recover their highs of that year. Greece’s ASE Index would have to more than quadruple to match its 2007 top.
American investors are willing to gamble on riskier assets in the euro region as they seek better valuations outside their home markets and expect the European Central Bank to continue supporting the economy, according to Raiffeisen Capital Management’s Herbert Perus.
The ECB introduced a negative deposit rate in June as it announced new long-term refinancing operations and said officials will start work on an asset-purchase plan. President Mario Draghialso indicated the central bank’s willingness to do more if necessary.
The fundamental positives for earnings growth seem in place and German and other European stocks are still at a valuation discount to the US:
At the same time, analysts estimate earnings growth for U.S. companies will be smaller than for European ones. Profit will climb 11 percent for those on the S&P 500 in 2015, compared with a 14 percent gain for the DAX, according to the average projection compiled by Bloomberg. Those listed on the PSI 20 will see a 43 percent jump in earnings next year, while they will rise 21 percent for the IBEX 35 and 25 percent for the FTSE MIB, the data show
Against the backdrop of positive fundamentals for Europe what explains the large one month selloff?
The major explanation is the heightened tensions between Russia and the Ukraine. Germany has the largest trade relations among European countries with Russia and the Ukraine. This has been the apparent reason for the weak performance of German stocks over all of 2014 but it has been even more pronounced recently.  In fact in the 3 days since the downing of the airliner over the Ukraine the DAX German index fell 2.5%.
A bit earlier in July the prospect of a renewed European debt crisis spooked investors for a brief period due to fears about the financial status of Portugal’s Espirito Santo Financial Group SA. Was it noise? As of the the market close in the US on July 24 both the Italy(EWI) is 3.8%  above its recent low closes on July 17.. Spain(EWP)is 3.6% above its low on that date

As seen from the one year charts below for EWI (Italy) EWP (Spain) EWG (Germany) and FEZ (Euro zone) all are still significantly below their recent highs.I have added the 200 day moving average to the charts. This is a widely used indicator as a buy sell signal. Those interested in a discussion of the use of moving averages as a meand of trend following/capturing the momentum factor might be interested in looking at the work of Mebane Faber here




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