This Week's Focus: Is there a bubble in European equities?
Tuesday, 19 of May 2015
This week focus
Is there a bubble in European equities?
After the strong rally lived so far this year for European equities, it is appropriate to ask whether equities remains an attractive option. We should remember that share prices and consequently the equity indices follow a market dynamics brought about by supply and demand. This is what we call financial flows and determine that a market will evolve positively or negatively based on net demand for its assets. In the case of the bag, a market rise occurs because buyers flows outweigh sales flows, resulting in rising prices.
The causes rationally explain that a market receive net purchase flows may come from the hand of valuations and expectations. On the latter, expectations of improved corporate earnings, due, for example, to an improvement in consumption or investment or both variables at once and can withstand a rising market because the expected return on investment in the stock market It will be higher than today.
Regarding the valuation of a company or market, we need to calculate the expected return of it and compare it with that of other financial assets or its evolution in historical terms. The relationship between corporate profits, measured in earnings per share, and the stock price is indicated as the ratio PER (Price to Earnings Ratio). A PER of 20 times is equivalent to an expected return of 5% to the current share price, while a 10 PER mean estimated that the return on equity is 10% on the initial investment value.
As stock indices are composed of several different companies shares, weighted by different mechanisms, for example by market capitalization, a PER ratio is calculated similarly to the value of the index but using their individual PER factor weighting.
Over the past 12 years, we have attended two bull markets (2003-2007; 2009-2015) and one of bassist (2007-2009) in the developed equity markets. If checked the PER of the period and examine its evolution, we see the following:
The main European markets except Germany recorded current valuations in terms of P close to their highs. It should be clarified that PER is calculated based on the profit for the last 12 months reported, so if in the coming quarters the company profits increase, the ratio PER decline if stock prices remain constant.
PER high but increased profits
The consensus of analysts expected corporate profits for the IBEX increase by increase by 37% in 2015 and 17.9% for 2016.
According to our model of fair value, current levels of IBEX, such are compatible with future earnings growth of 15%. Based on the latest data, corporate profits grew more than 35% in the last 12 months.
However, it should also be noted that in models of fair value involving the free interest rate risk, the sovereign long-term bond, which as mentioned in other reviews is clearly overrated due to the effects of the program debt purchase launched by the ECB.
Opportunity with caution
Thus attending to the basic elements of assessment, our opinion is that the main European stock indexes, including the EuroStoxx 50 selective area are generally expensive in terms of PER, with the exception of Germany which is slightly above its average, but far from maximum.
However, the realization that corporate profits in Europe have been relatively stagnant in recent years and that the conditions exist to expect an increase of the same in the next two years, we improved the evaluation in two years, bringing the multiples PER expected to levels more consistent with historical averages.
For these two reasons, and taking into account conditions on the expansive monetary policy applied by the ECB in the coming months, we believe European equities will remain a profitable asset but its route will always limit valuations reach levels close to highs or if expectations of improved profits are disappointed. In any case we do not appreciate any symptoms of a bubble.