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American investors about to get burned in Europe

Shares aren't cheap, and the euro crisis isn't fixed.

  • By Matthew Lynn,
  • MarketWatch
  • – 10/30/2013
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Forget the culture, the scenery, the food or the wine. What Americans love most about Europe right now are its stock markets.

Last week we learned that record amounts of cash are flowing into European equity funds. And a few high-profile investors such as John Paulson have been betting big on bombed-out markets such as Greece.

The trouble is, they are going to get burned.

Sure, valuations are cheap compared with other major markets. After three years of perpetual crisis and a deep recession, that is to be expected.

But sometimes things are cheap for a reason, and not just because the market has undervalued them. And anyone wagering that the euro zone's crisis has been fixed is making a big mistake. Company earnings can't keep increasing in the face of deflation, deepening recessions, a rising currency and political deadlock. And if companies can't make money, the stock market can't keep rising.

There is plenty of evidence that Americans, along with other global investors, have found a sudden enthusiasm for euro-zone stocks. In the week ending Oct. 23, investors poured $5 billion into European funds, the biggest-ever weekly inflow into that asset class. Throughout 2013, more money has been thrown at European stocks than at any stage since the single currency first ran into trouble back in 2009.

A few such as hedge-fund manager John Paulson — the man who made himself a fortune by betting on a meltdown in the subprime mortgage market — have made high-risk bets. His funds have been investing heavily in the burnt-out Greek banking sector, figuring that if the slump in that country finally comes to an end then the banks will be the first to recover. So have other well-known American hedge funds such as Och-Ziff and Falcon Edge.

So far they have been well rewarded.

The Euro Stoxx 50 index, which covers the biggest euro-zone companies by market value, has risen by 21% since hitting a low for the year back in June, and for the year as a whole it is up by 15%. With the euro also appreciating on the currency markets — it is up close to 1.40 to the dollar compared with 1.30 back in July — anyone who jumped on that trend early will have done well.

And yet even with the rise in prices, euro-zone equities are still cheap compared with the rest of the world. The Euro Stoxx 50 is 32% cheaper than the MSCI World Index of Developed Countries. It trades on a multiple of just 13.6 times this year's earnings, compared with 15.8 for the S&P 500 (.SPX), and 18.4 for Japan's Nikkei 225 index.

The logic of investing in the euro zone is not hard to follow right now. The European economy may have its problems but it is still home to dozens of world-class global companies. There plenty of customers for Airbus planes (EADSY), Mercedes cars (DDAIF), Accor Hotel rooms and L'Oreal (LRLCY) cosmetics, regardless of what is happening to the countries where those business are headquartered. If you can get them at cheaper prices than similar global businesses based in the U.S., Japan or Korea, it makes sense to pile in now.

The trouble is, the euro-zone crisis is far from fixed. The easy work has been done. The hard work is still ahead — and progress on that has stalled.

There are three big problems ahead.

The first is that the economy remains stuck in recession.

The upturn over the summer was based on confidence surveys. There were not many hard figures to back it up. The fact remains that major economies such as Italy are stuck in recession and France and Spain are only a whisker away from it. The Greek economy is still contracting and shows no sign of self-sustaining growth. True, stock markets can rise even when economies are shrinking, and there is still the possibility of the European Central Bank unleashing full-scale quantitative easing in the way the U.S. and U.K. have done.

But there are still limits to how far the markets can rise against that backdrop — people without jobs don't buy much, and without sales profits can't rise.

Next, there is looming political paralysis.

Germany is stuck without a government following last month's elections, and the negotiations to form a new coalition are torturous. And yet countries such as Greece and Portugal urgently need fresh bailouts — and that is not going to happen without a government in Berlin (and not with one fearing fresh elections either).

A far-larger issue is the elections for the European Parliament next May. Anti-euro parties from France's National Front, to the British U.K. Independence Party, to the Freedom Party in the Netherlands will make sweeping gains. The Parliament does not have a lot of power, but it can block things. Here's the problem. The euro still needs big steps toward integration to survive. How's that going to happen with euro-skeptics dominating the Parliament? The answer: it won't. From May, further progress to banking and economic union will be stymied.

Finally, the euro-zone big caps have muddled their way through the last couple of years by exporting their way out of trouble. They have managed to keep profits rising by selling more in North America and in fast-growing Asia even as they struggled in their home markets. At the same time, deep recessions and mass unemployment at home meant they could keep labor costs under control. That was all good for earnings – and kept the shares rising.

But there is a limit to how long they can keep that going. Even the mighty German export machine has spluttered — German exports fells by 1.1% in October. With the euro rising in value, it is going to be harder to sell to the rest of the world, but domestic demand won't take up the slack.

Through the early part of the year, there was a case for getting into the euro-zone equity markets. Prices were getting ridiculously cheap. But that is no longer true. The global money is pouring into Europe at precisely the wrong time, and is going to get burned.

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