Compared to the the start of the bull market six years ago, most European indices have doubled in price. As from a technical point of view bull markets usually last around five years, most investors are starting to feel ‘itchy’ and want to know whether or not markets are overvalued. I myself am one of these investors, and therefore I wanted to share my opinion with the general public.
In this article I will establish some pros and cons of buying European Equity stocks or indices. First of all, I will briefly introduce the current state of the European stock market by showing a 10-year total return graph. My benchmark for European Equities is the EUROSTOXX 600 index, weighted by market capitalization. I will subsequently dive into several economic events, such as the ECB Quantitative Easing program. The third section discusses the potential influence of bond yield on the stock market. After which I will provide you with a short discussion about potential political and economic issues that will influence the stock markets in the near future. I will end this article with my conclusions based on all listed data.
A Quick Overview of the Market
Looking at mid 2014 market prices in chart 1, it can be seen that European stock index prices have already increased up to a number close to their pre-crisis prices. This increase is, in my view, mainly due to the fact that the central banks of the United States started with their quantitative easing programs in late 2008, only weeks after the collapse of Lehman Brothers. Markets continued to decline heavily until investors were ready to trust the markets again in early 2009. This newly found trust in the market has given way for a six-year bull market in which most stock indices in the United States and Europe have doubled in value. What is interesting is that, despite major events like the Greece bailout by the IMF and the loss of investor confidence in the Eurozone in general, markets are still climbing. Even the more recent troubles in the Krim have not affected the generally increasing stock prices.
What is the Current State of the Market?
The first graph I show is of the stock prices in the last 12 months (Chart 2). I chose to show last year separately because rumors about quantitative easing programs by the European Central Bank (ECB) started spreading more heavily during this period. Its actual announcement on January 22nd therefore did not come as a surprise. The 12-month chart shows the actual impact on stock prices of the QE program coupled with lower oil prices and stronger dollar/euro prices. European stock markets have increased another 15-20% in the past two months alone!
Central Bank Influence
Most of the current positivism of investors is, in my opinion, due to a strong belief in the ECB. The Federal Reserve Bank in the U.S. launched four consecutive QE-programs from late 2008 until the end of 2014, and this has made investors believe in the effects of QE. The S&P500 has increased with about 200% from 735.09 on February 1st 2009 to 2101.04 at the moment this article was written. The Japanese Nikkei 225 has more than doubled since the announcement of the Japanese QE program, from 9625.99 points on November 1st 2010 to 18.971 at yesterday’s close. Looking at the increase in stock index prices, can we expect the same thing happening in the Eurozone? This is a question that is best left for another article. I will however point out certain other macroeconomic factors that might influence market prices.
The State of Bonds
With the recent ‘flight to safety’, European government bond prices have gone up radically, decreasing their effective interest rates.
German, Austrian, Dutch, Finnish, French and even Irish 10-year bond yields were below 1% in February 2015. Spanish and Italian 10-year bond yields are at around 1.25% annual interest.
As governments are able to obtain capital at lower rates, investors are looking for higher yields. As a result, they have turned to corporate bonds. This has reduced corporate bond yields to unequalled lows, which is reducing the interest rates that companies in the Eurozone are paying. Nestlé, one of the largest European companies in the index, has reached negative yields on its bonds at the start of February. In my opinion, major European companies will be able to reduce their interest costs by selling more bonds into the market at lower interest rates. This will boost earnings and increase company value, allowing for higher stock prices.
These highly rated corporate and government bonds will still be bought by institutional investors. Pension funds and insurance companies are obliged by their own policies to keep their Strategic Asset Allocation in bonds, implying they should keep buying bonds despite those bonds giving low to negative returns. This also implies that there will be a semi-constant demand for ‘safe’ bonds from AA-AAA governments such as Germany and the Netherlands. It should be noted that institutional investors make up the largest part of the bond and stock market.
From a different perspective, smaller investors with an investment portfolio of below 100,000 Euros are unlikely to buy such bonds as a safety measure. Due to the depositor guarantee system in that is in place for most European banks, amounts up to 100,000 Euros are covered by other European banks and governments, making deposit interest rates as safe as government bonds. As deposit interest rates are, generally, higher than European bond yields, it is safe to say that most small investors will not invest as heavily in the European government bond market. Despite of the relatively smaller share these private investors hold in the market, their share should be taken into account when discussing the state of the bond market.
So why am I discussing government and corporate bond yields? It is quite simple: as bond and deposit yields are declining by the month, investors will be looking towards higher yields with higher risks attached. In other words, investors will not only start looking at high-yield corporate bonds but also at stock markets. This implies that the demand for shares will be higher and stock markets might increase in the future due to these low bond prices.
Despite the QE program launched by the ECB and decreasing bond yields, there are several issues in the Eurozone that might influence the stock markets. Most of these issues are a whole other discussion in themselves and are often discussed in newspapers, such as the Greek debt crisis, the Russian invasion of the Krim and the French reluctance to reform the economy. These events have had their influence on stock market prices, as far as investors are concerned, but are more or less forgotten for the moment. Whether events such as these will have a future impact on markets is highly debatable. I will leave these events as examples of potential future problems that are not relevant at the moment.
Looking back at all the news articles, news reports and scientific papers I have read over the past years, the future of European stock markets is still cloudy/unclear.. Even though there are some signs of potential earnings increases due to interest costs and increasing share prices and the search for higher returns, I also have a nagging suspicion bond prices might have inflated too much. I am unsure what will happen when bond yields start increasing, but I doubt stock markets will be left untouched. For the moment however, with QE in their wake, European stock markets are looking as bright as ever with more potential in the near future. I would like to finish this article with a chart and a question: at what point of time are we, Euphoria or Optimism?
Disclaimer: Tjard de Wolf holds no position in European Equity markets. He does not advise you to buy or sell stock in European Equity markets.
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Tjard de Wolf
Tjard looks at the markets from a long-term, rather fundamental, point of view.