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Europe on 1 Billion Euros a Day
Last summer, an American tourist in Paris would have laid out almost $29 for a ride to the top of the Eiffel Tower and a one-day pass to the Louvre. Today, gaining entrance to those two iconic attractions would cost only $22 - or 24% less. Thanks to a strong dollar, a European vacation is on sale...
So are European stocks.
But that's not all; the greenback's spectacular ascent during the last several months has created a world of investment opportunity for the dollar-based investor. Therefore, we repeat the question we first asked a few weeks ago, "Why not swap some richly valued dollars for attractive non-dollar assets... even if that 'asset' were nothing more than a Parisian holiday?"
If Paris isn't your "thing," here's another idea: Sell U.S. stocks and buy European stocks... as a "pairs trade."
That's right: Sell short the SPDR S&P 500 ETF Trust (NYSE: SPY) and then buy an equivalent dollar amount of the SPDR Euro Stoxx 50 ETF (NYSE: FEZ). This sort of pairs trade is a classic "convergence trade," which succeeds if the valuations of U.S. stocks and European stocks converge toward one another. (On the other hand, the trade would produce losses if the valuations of U.S. stocks and European stocks diverged from one another.)
We have never before proposed this trade... and that's a good thing. It would have been a big, fat loser during the last five years. If an investor had put this trade on at the end of 2009 and stayed with it until now, he'd be down 70%. That would have been a very bad trade.
But that's just one reason why it might now be a good trade, or at least a mediocre one. No trend lasts forever.
For several years running, the U.S. stock market has been a one-directional market: Up. But maybe it is capable of moving in a different direction, like sideways... or even down. Who knows?
What we do know is that U.S. stocks have been big winners, relative to European stocks, during the last five years. The S&P 500 ETF has doubled, while the Euro Stoxx has gained a miserable 6%, total - that's barely 1% per year.
As a result of this impressive, five-year divergence, U.S. stocks have become very richly priced, not just relative to European stocks, but also relative to most foreign stocks around the globe. The chart below tells the tale. Relative to the S&P 500 Index, the MSCI EAFE Index of international stocks has been drifting to ever-lower valuations, based on price-to-sales and price-to-EBITDA (i.e., a metric that approximates cash flow).
European stocks have followed a similar trajectory and now trade at very deep discounts to U.S. stocks. Based on price-to-sales, the European stocks in the Euro Stoxx sell for 46% less than the U.S. stocks in the S&P 500. Based on price-to-EBITDA, they sell for 36% less than U.S. stocks.
It is possible, of course, that U.S. stocks will continue their world-beating performance and will continue to diverge from European stocks. But valuation convergence seems like the path of least resistance from here. U.S. stocks may not suffer any major reversals, but one way or another, they will likely lose some of their premium pricing relative to European stocks.
Here's why: During the last two decades, the valuation gap between U.S. and European stocks has never been wider than it is today. Secondly, a great big wave of monetary stimulus is just about to hit the European financial system, and this wave will hit at the same time that monetary stimulus will be ebbing from the U.S. financial system.
The relevant term is quantitative easing, or QE. It's an elegant term for "money printing." Here in the U.S., our Federal Reserve conducted this practice for nearly six years before halting it last October. Over in Europe, QE is just starting. The European Central Bank has pledged to purchase $1.15 trillion worth of publicly traded debt during the next two years - using money that it conjures out of thin air.
Whatever the hazards or flaws of QE may be, the U.S. experience has demonstrated that QE programs are wonderful for pumping up share prices.
Between March of 2009 and October of last year, the Fed's QE programs spent $2.6 trillion buying up U.S. Treasury and agency debt. During the same time frame, the total capitalization of the U.S. stock market skyrocketed from $9.4 trillion to $14.4 trillion. That works out to about $5.7 trillion of additional market cap for every QE dollar spent. Not bad!
In terms of "S&P 500 points," the math doesn't seem quite as impressive. (But remember, the money is "free," so who cares?) The S&P 500 Index gained one point for every $2 billion spent under QE.
Just for kicks, let's assume the European Central Bank's (ECB) new QE program produces an identical effect in the European markets during the next two years - i.e. every euro of QE spending produces 5.7 euros of additional market cap.
If that were to occur, the combined market capitalization of the 19 eurozone stock markets would double from 6.4 trillion euros to 12.8 trillion euros!
QE is not the only factor influencing stock prices, of course. But recent history suggests it is a very important one.
Bottom line: The ECB's quantitative easing campaign could light a fire - or at least a few candles - under the European stock markets. The revitalized European stock markets could, in turn, begin to suck capital away from the U.S. stock market, thereby promoting a valuation convergence between eurozone and U.S. stocks.
The pairs trade we propose would prosper from such a convergence, without subjecting investors to "directional volatility." In other words, this pairs trade could succeed, even if global markets are falling, provided that the U.S. markets fall more than European ones.
But short-selling isn't for everyone - in fact, it's almost for no one - so if that's not your thing, keep it simple. Sell U.S. Buy Europe.
Good investing,
Eric J. Fry
for Free Market Café
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