December 3, 2013 / 5:36 PM / 5 years ago

Analysis: U.S. investors embrace European stocks as prospects improve

NEW YORK (Reuters) - U.S. investors have become increasingly enthusiastic about buying stocks across the Atlantic, seeing the European Central Bank’s commitment to a loose monetary policy as an invitation to bet on risk there despite a wobbly underlying economy.

Traders are pictured at their desks in front of the DAX board at the Frankfurt stock exchange November 27, 2013. REUTERS/Remote/Stringer

European stocks reached five-year highs early last month, with the FTSEurofirst 300 index of top shares in the region up nearly 17 percent since late June, fueled by the massive global central bank stimulus and improvements in economic data.

American-based investors see the potential for profit growth, anticipating improvement in the euro zone. There is some concern, however, that the run across the Atlantic has gotten overzealous. Valuations are still favorable when compared with the United States, though that gap has been narrowing.

“There are many reasons to be encouraged by Europe and I believe there is more upside than downside in investing there,” said Audrey Kaplan, senior portfolio manager and head of global equities at Federated Investors in New York.

Given Europe’s recent tendency for slower growth than the U.S., it is possible most of the run has been wrung out of markets. Germany’s has gained 14 percent in just the last three months, while Spain’s has risen 16 percent.

European equity funds, which include U.S.-domiciled conventional funds and exchange-traded funds, have seen net inflows for 22 consecutive weeks for a net inflow of $20.5 billion year-to-date, the largest since 2006, according to Lipper, a Thomson Reuters company.

ETF demand ramped up in August, September and October showing inflows at about $4 billion each. While interest slowed in November it remained robust, with inflows through the week ended November 27 at $1.6 billion.

“This is a catch-up for investors who reduced their exposure to Europe because of economic weakness and uncertainty, and now they are rebuilding positions,” said Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ in New York.

The question is whether this run has reached its peak, or whether ECB liquidity can provide the same kind of fuel for those markets as the Fed’s stimulus did for U.S. equities. Right now, European stocks do not look as rich as their overseas cousins, but that doesn’t mean they aren’t expensive.

The U.S. S&P 500 is trading at 15.3 times expected earnings while Europe’s broad stock index, STOXX 600, is running at 13.5 times expected earnings.

The cyclically adjusted price/earnings, or CAPE, ratio, suggests that European equities are undervalued from a historical perspective, according to London-based consultancy Capital Economics.

The CAPE ratio compares the current price of a stock market with the average level of earnings over the past 10 years after adjusting for inflation.

That ratio for euro zone equities was recently at 12.3, below its 30-year average of 17. The equivalent CAPE ratio for U.S. equities is around 21.5, above its 30-year average of about 20, the firm calculated.

GERMAN STOCKS IN DEMAND

Germany’s stock index has been hitting new highs nearly every day, but its annual gain of 24 percent is below Greece’s 32 percent, the best performer in the euro zone.

While Greek stocks are rebounding from historic lows, many investors remain wary of equities from periphery countries.

Federated’s Kaplan, who is part of a team that manages $2.5 billion in assets, said she is overweight German equities by 15 percent, but remains “cautious” on southern European stocks.

“We anticipate the German recovery will continue to gain momentum into next year,” Kaplan said, pointing to recent data showing strong factory orders as euro zone car sales surged.

The ECB’s rate cut pushed the euro down from a two-year high, which should benefit Germany’s export-reliant economy.

The European Commission last month forecast 1.1 percent growth in the euro zone in 2014 after a 0.4 percent contraction this year. U.S. GDP grew 2.8 percent in the third quarter.

Guillermo Felices, head of European asset allocation at Barclays in London, said he recommends going “short” U.S. equities versus long a basket of Germany’s, Europe’s and Japan’s indices.

Longs are bets that profit when stocks rise, while the opposite holds true for short positioning.

To be sure, growth in the euro zone remains anemic and unemployment is still at record highs in some countries.

“We are increasingly wary of European consumer-staple companies dependent on emerging markets for growth and in Europe we find fewer interesting buys among the mega-caps and many more among mid-size to large companies,” said John Allison, chief executive at Unio Capital in New York.

Allison and others, however, believe continued improvement in the region will drive growth. He recently bought European equities, which at 40 percent of his global portfolio equals his exposure to U.S. assets.

“There is no reason to believe that these flows into European stocks will stop anytime soon,” he said.

Reporting by Julie Haviv and additional reporting by Ashley Lau; editing by Andrew Hay

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