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Worry about the eurozone crisis if you like. But profit, too

How much the economy does or doesn’t grow from here is neither here nor there for the stock market

14 February 2015

9:00 AM

14 February 2015

9:00 AM

If you want something to worry about, you need only cast your eye across the channel to find yourself spoilt for choice. There is the background noise of massive unrepayable sovereign debt levels. There’s huge youth unemployment. There are angry minority political parties — note the rise of Spain’s anti-austerity party Podemos. There is the battle between those who think the eurozone can survive as just a monetary union and those who know that it will only survive if it gives into political union.

There is the threat of deflation (nice when you aren’t in debt, crippling when you are). There is the new phenomenon of negative yields, whereby desperate investors are prepared to pay more for sovereign bonds (and the occasional corporate bond) than they know it is possible to get back if they hold the bond to maturity. Yields on more than $3 trillion worth of sovereign debt are already negative.

And of course there is brinkmanship in Greece, with the odds of a Greek departure from the euro by the end of the year getting better and better every day and Russia prepared to consider backing the country’s rebellious new government if the rest of the EU won’t. It’s a mess. And if the Greeks don’t start being nice to the Germans soon (or visa versa) it’s going to turn into more of a mess.

But all this confusion and chaos has done one good thing. It has made global investors confuse stock markets with economies and overlook the strength of many of Europe’s companies, big and small. And it has made those companies much cheaper to buy than they would have been otherwise. The first thing to note here is that the eurozone economies, while not exactly at their best, are also not in as dismal a shape as you might think: most manufacturing surveys are telling us activity is on the up; consumption is rising slightly; and the economic surprise index (which tells you how reality differs from forecasts) has turned positive.


The second thing to note is that how much the economy does or doesn’t grow from here is neither here nor there for the stock market. Academics have passed countless well-paid hours investigating the link between economic growth and stock market returns. Their final conclusion? There isn’t one. Instead stock market returns are a function of two things. In the short term it is liquidity — how much money there is knocking around to buy shares. And in the long term it is valuations: buy them when they are cheap and you’ll make money over the medium to long term; buy them when they are expensive and mostly you won’t.

So on to liquidity. Obviously, here there is little but good news. The ECB’s quantitative easing programme, announced in January, appears to be the real deal, so we can soon expect to see a huge amount of new money poured into the market to spread its fairy dust around the asset classes. But according to the liquidity specialist Cross Border Capital, there is other good news too: eurozone private-sector liquidity is also ‘fast increasing’ and was doing so even before the QE announcement. Their conclusion? ‘The eurozone is already in recovery from a flow of funds standpoint.’

If history is any guide, that should mean that asset prices recover too. That is particularly the case if you look at yields (if a bond is yielding zero, a share doesn’t have to give much to look good) and at valuations. Analysts are prone to a mild fixation on price/earnings ratios. Look at these for most European markets and you might not think they look that cheap. But short-term p/e ratios are to markets as economic growth rates are to markets: mostly irrelevant. More relevant is the cyclically adjusted p/e ratio (Cape) developed by the Nobel-winning economist Robert Shiller in the early 1980s. You can find out exactly how Cape is calculated on the internet in a matter of seconds, so here I will just point out that it has a very good record of predicting long-term market returns and that today it is telling us to buy into European equities. According to Luca Paolini at Pictet Asset Management, if you look at the difference in Cape between the US and Europe as a whole, ‘European equities trade at a record discount of some 33 per cent versus US stocks.’ And that’s at a time when the weak euro is doing wonderful things for German exporters and the strong dollar is beginning to hurt US exporters.

I was lucky enough to interview Shiller himself last week. I asked him how confident he was in the measure: would he be happy buying, say, the four lowest Cape markets in Europe and holding them for ten years? I have to report that he wasn’t entirely certain that he could bring himself to put his own pension into the cheapest market out there — Greece, on a Cape of 3.4 times (the US is on around 27.8 times). But he is tempted by the slightly less bonkers markets: their ‘long history of greatness’ has prompted him to buy into Spain (10.7 times) and Italy (8.5 times) on the cheap. You could do worse than to follow him. You can do so with a simple exchange traded fund that just tracks the market as a whole or with a more expensive actively managed fund (perhaps Jupiter European Opportunities).

Otherwise you could buy a new fund which Shiller has worked with Barclays and asset-management firm Ossiam to produce, currently known as the Ossiam Shiller Barclays Europe Sector Value TR UCITS ETF 1C. The idea here is to use the Cape ratio to identify, buy and hold the cheapest sectors in the market, something back-testing suggests returns some five percentage points a year higher than those you would get from just tracking the wider index. The fund will be listed in a week (16 February), by which time I assume the parties involved will have thought of a less stupid name for it.

Or else if you really want to own a holiday home in Europe, you might want to get on the phone to a friendly estate agent. I can’t see why you would: hotels and villa rentals are convenient, easy, and unlikely to hit you with annual property or wealth taxes. But if you must, the cheap euro and the fact that sharp rises in liquidity usually find their way into the property market one way or another both make now a perfectly reasonable time to buy.

Merryn Somerset Webb is editor in chief of MoneyWeek.

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