European stock markets overall have fallen this year and plunged by over 20% during the past 12 months, measured in dollar terms using either the MSCI Euro or Euro Stoxx 50 indexes. At the same time, U.S. stocks have posted solid gains. While Europe is in an economic
recession and clearly faces fiscal challenges, has the market fully adjusted for these concerns, or even over-reacted, creating a contrarian investment opportunity for U.S.-based investors? In other words, are European stocks a good value? We doubt it.
In general, European stocks are not inexpensive relative to U.S. stocks. This is because earnings per share in Europe have been falling along with prices, keeping price-to-earnings (PE) ratios from offering an attractive discount. Generally speaking, European stocks typically trade at about a 20% discount to U.S. stocks. With European stocks at a PE ratio of about 11 and U.S. stocks at 13, European stocks are not at a discount to their historical relative valuation to U.S. stocks. In fact, U.S. stocks are 5% cheaper relative to their long-term average PE ratio than European stocks.
The reason Europe is not getting cheaper is that Europe's labor rules mean that when output drops, European companies cannot cut their labor costs to the same degree as U.S. companies can. With higher fixed costs than U.S. companies, European corporations see more of a reduction in earnings than headcount when revenues fall.
While the Eurozone unemployment rate has risen, despite being in
recession it is only about 1.5% higher than it has been on average over the past 20 years. By comparison, in the U.S. where growth continues, it is 2.2% higher. Even more directly as it relates to profits, the labor cost to produce a unit of output has risen much faster in the Eurozone over the last decade and continues to rise through the downturn in countries such as Italy, France, and Portugal. At the same time, labor costs per unit have remained much tamer in the United States. With labor generally comprising about 70% of business costs, this can have a big impact on profits.
While European stocks are likely to present an attractive investment at some point, their values do not compensate for the heightened risk to corporate profits as the Eurozone struggles to define its future economically, politically and socially.
Jeffrey Kleintop is the chief market strategist for LPL Financial.
