Morgan Stanley (NYSE:MS) analysts have noted for the last four months that U.S. equities are more expensive relative to European stocks. The trailing Price over Earnings (P/E) ratio for MSCI Europe is 15.5 and for the U.S. is 17.1. Also, on both a price to cash flow and a dividend yield basis, the MSCI Europe shows a better value. Price to cash flow for U.S. is 10.9 and for MSCI Europe is 8.2. Dividend yields are also higher in Europe coming in at 3.4 percent versus 2.1 percent in the U.S. Overall, European equities are trading at about a 30 percent discount relative to their U.S. counterparts. Morgan Stanley (NYSE:MS) analysts also note that the MSCI Europe Return on Equity (ROE) is about 36 percent lower than the equivalent measure in the U.S.

European valuation premium

Are European equities trading lower?

Are European equities trading lower because they indeed have lower growth potential or are U.S. equities expensive with their above average profits? Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE) analysts seek to answer this question by using Robert Shiller’s cyclically adjusted price earnings ratio (CAPE). In order to compare the U.S. and Europe fairly, Societe Generale analysts modified the CAPE by using MSCI generated series using cash flow from operations and excluding write offs. Robert Shiller does account for write offs in his S&P 500 core profit series, which has a downward impact on CAPE. However, the conclusions reached using the MSCI modified series do not change. Societe Generale analysts use the real price divided by the ten year average of real earnings to arrive at CAPE.

The average discount of European stocks versus U.S. stocks

According to the MSCI CAPE, European equities are trading at a 36 percent discount relative to U.S. stocks. The average discount of European stocks versus U.S. stocks since 1980 is 8 percent, so the pricing divergence is almost 5 times above such average.

U.S. equities are also expensive against themselves using the MSCI CAPE. Their average P/E is around 17.2 since 1980 and the current P/E is 21.6, a 25 percent overvaluation relative to the average. Moving back to the average CAPE will put the S&P 500 at approximately 1,230. For Europe, Societe Generale found that the average P/E over the last 34 years is 15.9 versus a current CAPE of 13.8, a 13 percent discount relative to history.

European stocks’ earnings lagged

A key driver of the U.S./Europe valuation difference has been the faster recovery of profits in the U.S. to pre-crisis levels while European stocks’ earnings lagged. The chart below generated by Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE) shows that US profits have been about 25 percent above their 10 year moving average while European profits have been about 10 percent below their respective 10 year moving average.

Societe Generale analysts argue that even though U.S. stocks have better margins, higher than average profits relative to the 10 year moving average limits future upside. On the other hand, European equities with their depressed margins have a better probability of providing medium to long term upside. Societe Generale tested this idea by ranking real profits against the 10 year moving average by quintiles and then measuring the annualized returns of equity indices for the next five years. Indeed, above average profitability led to lower equity returns in the next 5 year period.

Currently, the U.S. CAPE of 21.6 coincides with a possible profitability shown in quintile 4 of the chart below. Societe Generale analysts highlight that higher than average profitability of U.S. stocks coincides with a higher CAPE. Furthermore, not only profits revert to their long term average but prices do as well. If equity investors think continuously high profits in the U.S. are sustainable, they are going against market earning cycles and equity valuations, two factors that combined can cause 45 percent likelihood of negative return.

Europe has more upside potential for the next five years

In contrast, Europe has more upside potential for the next five years as profits are still below 10 year averages and current margins are in the lowest quintile providing high probability of upside. The 13.8 CAPE is consistent with better returns as well. Even though is hard to imagine a depressed region recovering, the downside risks of investing when margins and valuations surpass historical averages significantly should not be underestimated. Mean reversion may be delayed for U.S. stocks, but when it comes both profits and prices will decline, in Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE)’s view.