LP L FINANCIAL R E S E AR C H

Weekly Market Commentary

July 30, 2012

Are European Stocks a Good Value?

Jeffrey Kleintop, CFA
Chief Market Strategist LPL Financial

Highlights
Given the plunge in European stocks over the past year, 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.

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 [Figure 1]. In fact, U.S. stocks are 5% cheaper relative to their long-term average PE ratio than European stocks. 1 PE Ratio by World Market
PE Ratio 10.0 9.7 8.6 21.4 8.2 10.3 9.7 10.3 11.0 13.1

Markets France Germany Greece

U.S. stocks are 5% cheaper relative to their long-term average PE ratio than European stocks.

Ireland Italy Portugal Spain UK Average United States

Source: LPL Financial, FactSet Research Systems 07/27/12

The reason Europe is not getting cheaper is that Europes 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.

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W E E KLY MARKE T CO MME N TAR Y

Labor Costs Are Stubbornly High in Many Eurozone Countries Relative to the United States
Labor Cost Per Unit of Output by Economy United States France Portugal Spain Italy

1.5 1.4 1.3 1.2 1.1 1.0 0.9

00 01 02 03 04 05 06 07 08 09 10 11 12

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 (as you can see in Figure 2). 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. n

Source: LPL Financial, Bloomberg data, Organisation for Economic Co-operation and Development (OECD) 07/27/12 IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. The MSCI Europe Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed markets in Europe. As of June 2007, the MSCI Europe Index consisted of the following 16 developed market country indices: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom. The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Stock investing may involve risk including loss of principal.

This research material has been prepared by LPL Financial. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.
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