European stocks are worth a long position

Kathleen Brooks
IN THE next few weeks we should get a better idea of how far the economic recovery has boosted profits at Europe’s largest companies as they report first quarter earnings. So far consensus estimates for earnings growth this year is a whopping 39 per cent up on last year.

This week French luxury goods group LVMH, food group Danone and supermarket chain Carrefour release results, along with Germany’s Hugo Boss and Debenhams, Qinetiq and Rio Tinto in the UK. So, should investors be as excited as the equity analysts?

Yes, says Philip Isherwood, equities strategist at Evolution Securities. “I think there is a case for strong earnings this year and next in Europe. The last year or so has seen a lot of cost cutting by companies and strong sales growth, which should sustain strong earnings. Those companies that have high operational gearing and can scale up their business as we emerge from the economic downturn are positioned particularly well.”

For contracts for difference (CFD) traders there are added incentives to go long European equities. Firstly, CFD investors also receive dividends and the average dividend yield for European equities is expected to be 3.4 per cent this year. This is more attractive then the average dividend yield for stocks on the S&P 500, which is forecast to be a mere 1.9 per cent.

Secondly, European stocks look cheaper on a price-to-earnings (P/E) basis relative to their US counterparts. Analysts expect stocks on the MSCI Europe index to trade on an average P/E ratio of 13.7 times earnings, compared with 15.3 times for stocks on the S&P 500.

Evolution’s Isherwood says that this should appeal to value investors: “US equities have been expensive relative to European equities for some time. However, by and large all developed market equity indices move together, so relative cheapness can be a comfort to investors. If you are searching for value then buying cheaper European equities would be a good thing.”

Thirdly, UBS analysts highlight that European equities have underperformed their US counterparts by 9 per cent in US dollar terms and 3 per cent in local currency terms since the start of the year. Some of this underperformance is due to the ongoing debt problems in Greece, but although there are short-term uncertainties for the economies of Europe, companies that have global exposure should continue to do well.

The key thing for CFD traders is to look for European companies with exposure to global markets rather than domestic markets, says Isherwood. He is particularly interested in looking for companies that can benefit from Chinese demand for raw materials, such as the mining, oil and gas sectors. “China is at the front of the global supply chain. As long as China can sustain growth then that is good for commodity companies based in Europe.”

Other sectors could also benefit. Some European companies with high international exposure to the global economy are cheap relative to their global peers, according to analysis by UBS. In particular, brewer SABMiller, which is listed on the FTSE 100, French industrial company Lafarge and Norwegian fertiliser company Yara.

The global French cosmetics company L’Oreal, which announced first quarter results on 22 April, performed relatively well during the recession because of its global reach.

For investors who want a broad-based exposure to European firms, Evolution’s Isherwood recommends long positions in the German Dax index, the FTSE 100 or Norway’s Oslo Stock Exchange. He likes Norway because it is an oil-driven economy and the FTSE 100 because it derives 60 per cent of its earnings from outside the UK. Even though Germany’s largest market is the Eurozone, it is still the world’s second’s largest exporter. “They sell everywhere, also Germany doesn’t have the fiscal problems that can slow growth elsewhere in the Eurozone,” says Isherwood.

In contrast, Isherwood urges investors to avoid stock indices that are exposed to domestic markets in Europe, especially in countries that have large fiscal deficits such as Spain, Portugal and Ireland, since fiscal consolidation could affect economic growth.

As long as there isn’t another global recession, he believes that earnings growth could persist for European companies for the next five to seven years. The Shiller P/E ratio for Europe (see chart), based on the average of 10-year historical earnings, also supports a period of strong returns. It suggests that European stocks need to appreciate by nearly 40 per cent to get back to their average P/E ratio of the last 25 years.

But Morgan Stanley is more moderate in its expectations for this year. It recently increased its 12-month price expectation for the MSCI Europe index from 1,030 to 1,280, implying a 9 per cent upside this year. It is particularly positive about sectors including staples, energy, pharma and industrial firms, which benefit from a weak euro, the currency has fallen by 10 per cent against the US dollar since the start of the year.

The MSCI Europe equity index has risen by 50 per cent since March last year and Morgan Stanley argues that it could be due a breather before embarking on another leg higher. It has found that in the past when the MSCI Europe index has risen by 50 per cent the index has fallen during the next six months, before picking up again (see chart). Investors should take advantage of this by purchasing European equities on the dips. Interest rates are low, so it is cheap to hold CFDs for a prolonged period and profit from a continuation in European stocks’ up-trend.



My pick: Long the FTSE 100 at 5,700
Expertise: Technical analysis
Average time frame of trades: 5-10 days
Last week we recommended buying the market at 5,700, and the trade has now triggered to put us in the position. We saw some good upside follow through in the early portion of last week, before losing momentum on Wednesday and Thursday. However, set-backs were well supported just below 5,700 and the market now looks poised to extend gains towards our objective of 6,000. We have moved our stop-loss to break-even to eliminate risk.


My pick: Sell crude oil
Expertise: Global macro
Average time frame of trades: 3 months
Commodities, stocks, and higher-yielding currencies have done well on speculation the global economy may register above-trend growth in 2010. But crude oil prices should ease over the next few weeks mostly because of dollar strength. The Federal Reserve is now expected to hike rates by nearly 90 bps over the next year. Eventually, a widening of the interest rate differential between the US and other countries will boost the dollar, making commodities more affordable.


My pick: Short silver
Expertise: Global macro, classic technical analysis
Average time frame of trades: 1 week-6 months
Silver’s positioning is showing signs of fading strength with negative divergence on 14-day relative strength studies as prices test resistance in the $18.25-$18.84 congestion region. However, an entry signal is lacking and I will look for a bearish reversal candlestick set-up on the daily chart below $19 to short. The start of the first quarter earnings season may prove to be the catalyst for the downturn with silver’s correlation to the MSCI World Stock Index now at 0.91.