Draghi Stock Rally Runs to Record Price-Earnings RatioAlexis Xydias
The two-year rally that has restored more than $4 trillion to European share prices is sending equity valuations to levels not seen in a decade just as investors turn away from record low bond yields.
Gains have pushed the Stoxx Europe 600 Index to 17.5 times annual earnings, the highest since 2002, data compiled by Bloomberg show. Companies trading at above-average multiples such as Kingfisher Plc, the London-based home-products maker, and steelmaker Vallourec SA in Boulogne-Billancourt, France, tumbled in the past month after reporting disappointing earnings.
While corporate dividends are higher than bond yields after two years of stimulus by European Central Bank President Mario Draghi, they’re luring investors to companies with unjustified valuations, according to Graham Bishop, an equity strategist at Exane BNP Paribas in London. Payouts that exceed the interest on German bunds by more than 2 percentage points will be little comfort as earnings growth falters and the economic recovery sputters, he said.
“The great rotation is an argument you could have made at any time in the past few years, the difference now is that the starting point with valuations is much worse,” Bishop said in a phone interview June 3. “What’s embedded into prices now is unlikely to be realized.”
The advance in the Stoxx 600 since June 2012 has pushed the gauge up 48 percent and sent its price-earnings ratio 26 percent above its decade average relative to reported earnings, according to Bloomberg data. Gains in stocks from Paris-based Total SA to Banco Santander SA in Madrid accelerated even as analysts have cut annual forecasts for the index by 6 percent. The overall market value for the index has climbed to $12.1 trillion from $7.9 trillion in June 2012.
The Stoxx 600 was little changed last week, closing at 347.07 after advancing since the start of May in the longest streak in two years. It fell 0.1 percent to 346.75 at 8:21 a.m. in London today. The Euro Stoxx 50 Index for euro-area equities slipped 0.3 percent to 3,273.64.
Since taking over at the ECB in November 2011, Draghi, 66, has pledged to hold borrowing costs low for an extended period and vowed in July 2012 to do “whatever it takes” to help the euro.
On June 5, he unveiled unprecedented measures to stimulate an economy threatened by deflation, cutting the key interest rate, charging banks for parking deposits and announcing a 400 billion-euro ($541 billion) liquidity channel. He stopped short of announcing asset purchases as done by the Bank of England, the Federal Reserve and Bank of Japan.
“Central-bank liquidity plans only have a big positive impact on the markets when they are very oversold,” Matt Maley, an equity strategist at Boston-based Miller Tabak & Co. LLC, wrote in a June 13 e-mail. “This time, the European stock markets have already priced in the stimulus,” he said. “The stock market is way ahead of fundamentals.”
Draghi’s policies have encouraged investors to bid up European assets from bonds to stocks and avoid cash. They’ve added $43 billion to European mutual and exchange-traded funds traded in the U.S. this year, according to EPFR Global data tracked by Bank of America Corp. Meanwhile, they poured $3.3 billion into American equities funds.
The Stoxx 600 and the Euro Stoxx 50 have gained 5.7 percent and 5.6 percent this year, while Barclays Plc’s EuroAgg Treasury Total Return Index of government bonds, which includes repayments, has increased 6.2 percent. The Barclays Pan European Aggregate Corporate Total Return Index has risen 5.2 percent.
Yields on 10-year Spanish bonds fell on June 9 to a record low of 2.58 percent from as high as 7.62 percent in July 2012, when concern grew that some European nations would struggle to pay back debt. They dropped below the yield on U.S. Treasuries for the first time since 2010 on that date. The yield on Barclays’ Aggregate Corporate index declined on June 6 to a record low of 1.99 percent, Bloomberg data show.
The Stoxx 600 now pays 1.52 percentage points more in dividends than corporate bonds, the most on record, Bloomberg and Barclays data show. The yield is 75 basis points, or 0.75 percentage point, below the payout on the Pan-European High Yield Index of the least creditworthy borrowers, the smallest spread on record.
Against German government bonds, equities pay an extra 217 basis points. The spread to bund yields has widened every month this year after narrowing for eight consecutive months through December.
Equities are still worth buying because economic growth will pick up and make earnings estimates achievable, according to Samy Chaar, an investment strategist at Lombard Odier in Geneva. ECB policy is forcing investors up the risk scale in search for yield, he said.
The euro area ended its longest-ever recession in the second quarter of 2013 and a composite purchasing managers’ index from Markit showed expansion in May for an 11th consecutive time. Euro-area inflation slowed more than economists forecast in May, with the rate at less than half the ECB’s target for eight months.
The economy will expand 1.1 percent this year, according to 58 economists’ forecasts compiled by Bloomberg. That’s half the expected 2.2 percent growth in U.S. gross domestic product this year.
“What Draghi has let us know is that this will not be an environment about bonds versus equities, but one about anything versus cash,” Chaar, who helps oversee $220 billion, said in a phone interview on June 11. “When you come out of recession and have rising PMIs, it tends to be a good leading indicator for earnings.”
Stoxx 600 profits may climb 10 percent to 22.50 euros per share in 2014, according to more than 2,000 analyst estimates compiled by Bloomberg, after shrinking an average 1.6 percent in the last three years. The forecast has fallen from a predicted 16 percent growth rate to 23.80 euros in January.
Some companies have shown the estimates are too optimistic. Shares in Vallourec tumbled 11 percent on June 11 after the provider of steel pipes for the oil industry lowered a profit forecast for this year. The company cited an order review and economic deterioration in Brazil, as well as worsened demand in the Europe, Asia, the Middle-East and Africa division.
Kingfisher, Europe’s largest home-improvement retailer, signaled on May 29 that profit growth will slow in coming quarters, citing weak consumer confidence in France. Shares of the company declined 4.9 percent that day, the most since September 2011.
“It’s been quite a good rally and profit taking wouldn’t be a surprise,” Marshall Front, who manages $800 million as chief investment officer at Chicago-based Front Barnett Associates LLC, said in a phone interview. Selling is justified “against the context of profit expectations that haven’t been met recently.”