A troubled economy whose banks are sitting on billions of dollars of unrecognised bad debts. This was the received wisdom about the US, post sub-prime meltdown.
Yet the US bounced back. Consumer spending, business investment and now house prices are moving again. Meanwhile, Europe has lagged with the EuroStoxx 50 trading at less than half the level of early 2000.
When investors can buy good companies for modest valuations, their prospects are bright. But even here, caution must be the watchword: many companies are extremely successful re-investors of capital, right up until the point at which they are not.
Looking around the world with eyes fixed on the rear-view mirror would lead to a focus on China, where GDP growth has been in excess of 8 per cent for as far as the eye can see, or the US, which led the world out of the global financial crisis. But we may have already passed peak enthusiasm for those countries.
The ‘Shiller p/e’ is the ratio between the current price and average earnings in real terms in the previous 10 years. (It was popularised by Yale professor of economics Robert Shiller.) Few, if any, valuation metrics have better predictive value.
Currently the US is on a Shiller p/e of 20.4 compared to 13.0 for Europe. Historically, when the US Shiller p/e is more than 20, returns for the next 10 years have been less than 2 per cent (nominal) per annum. When the US Shiller p/e is below 15, as is now the case for Europe, annualised returns have been closer to 6 per cent.
Whether we are talking about companies, markets or even people, there is one immutable rule: mean reversion. Across time, the profit margins and returns of markets tend to return to their historic levels.
Looking at returns on equity (ROE), Spain and France are most notable for their current unnaturally low returns. In France, earnings would need to increase by almost 80 per cent to get back to normalised levels. With Spain the opportunity is even more extreme. With ROEs at 28 per cent of the average of the past decade, normalised ROEs would result in a three-folding of profits.
This data is buttressed by long-term margin analysis: the US is earning ‘peak margins’, while much of the rest of the world and, in particular, peripheral Europe, is trading at ‘trough margins’. If S&P 500 margins were to fall to the average of the period, this would knock roughly 25 per cent off US profits.
The combination of these two factors – a US market where valuations, margins and returns are at peak levels and a European market where the reverse is true – could be setting investors up for an extraordinary reversal of fortunes.
If both the US and Europe see normalisation of profit levels, while valuation multiples remain the same, then – ignoring higher dividends from Europe – we could see 44 per cent of additional returns out of Europe. Should earnings multiples equalise, then the outperformance could increase to more than 70 per cent.
