Historical discount of Europe against Wall Street but beware of the trap it hides

The Stoxx 600’s valuation based on earnings forecasts offers a 30% discount to Wall Street expectations. This gap has not been so big since 2005, but what should be a once-in-a-lifetime opportunity for investors, with the euro on the rocks, could turn into a death trap. First, because it seems difficult for the S&P 500 to maintain these levels, it still remains expensive. And second, because for the experts the harsh winter is not discounted in the profit expectations of European companies.

Russia’s invasion of Ukraine and the rate rally undertaken by central banks to contain inflation are marking the stock market year. The losses of the S&P 500 are around 20%, while in the Stoxx 600 they exceed 17%. The blow to the stock market has gone hand in hand with the blow to profit expectations. The war has accentuated the cut in the expectations of corporate profits in Europe. The profit forecast has plummeted nearly 30% for Stoxx 600 companies, compared to 24% for the S&P 500 this year. This circumstance has opened a large gap in future valuations between the two indices. The 12-month earnings-to-price ratio has widened to 2005 highs. The Stoxx 600 is bought at a historic 30% discount to the US benchmark.

But this circumstance includes a double trap that can suddenly make the gap disappear. The corporate profits of European companies are highly exposed to the prolongation of the conflict unleashed by Russia and to cuts in energy supplies. “The European market may be cheaper than the US market, but profits are more exposed to higher prices and the risk of energy rationing,” says Fabiana Fedeli, director of equity and multi-asset investments at M&G.

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He adds: “While European equities could do well on a long-term view, in the short term I would be concerned about the risk of further earnings cuts and an even weaker euro.” The European currency is trading below the dollar, something that has not happened since 2022. The worst thing is that the market had not yet settled into a prolonged scenario of war. . The depreciation against the dollar exceeds 12% this year, which hurts earnings expectations, when compared to the American ones.

Nor does it play in favor of the European stock market that the S&P 500 remains expensive compared to its historical average. The 12-month profit to price ratio is trading above 16 times, while the average stands at 15.5 times. The Stoxx 600 is trading at nearly 11 times, down from its 13.5 times average.

For Emmanuel Cau, head of the European stock market at Barclays, the great risk is a new cut in profits and he recommends his clients not to rush into companies from the Old Continent despite the apparent historical opportunity.

“European equities are much cheaper both in relative and absolute terms, but the negative drivers in Europe are too big now,” says Florent Pochon, analyst at Natixis. Experts from the US share this point of view. David Kostin, Goldman Sachs’ chief strategist for the US stock market, believes that while the outlook for the US economy is uncertain, “the situation in Europe is dire”, pointing to energy prices and the war.

But not all experts are negative. “Most of the damage is done,” defends Ulrich Urbahn, Berenberg’s chief strategy officer. “In the fourth quarter, there could be very good buying opportunities.”

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