Cyclicals are the most expensive part of the European market right now, with almost record high valuations using both normalized PE and Shiller PE, according to Morgan Stanley (NYSE:MS) strategist Graham Secker, while telecoms and the energy sector have the lowest margins versus history. The combination of political risk, crowded positions, and tapering which is anticipated to begin by the end of the year, there have been more flows into European equities recently, and many people are predicting that prices will continue to rise. The big question in valuations right now is whether or not Europe’s EPS recovery has already been priced in.
Europe’s PE expansion
“Europe’s PE has been rising for two years now in the face of consistently falling EPS,” writes Secker. “This is in contrast to the US, where multiple expansion has occurred in combination with rising EPS. The length of this period of European multiple expansion in the face of falling EPS is very unusual.”
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Cyclicals above long-term median valuations
Secker thinks that European equities look undervalued right now, but that value is concentrated in just a few sectors: energy, finance, telecoms, and utilities, which pull down the average significantly. Cyclicals such as consumer services, media, capital goods, and the auto sector are actually above their long-term median valuations measured by Shiller PE, though they are close to the long-term average measured in absolute terms.
“While it is not uncommon for cyclicals to look expensive as we start a new profit cycle,” writes Secker, “these sectors are likely to be particularly vulnerable if we see any weakness in economic data news flow.” A system shock, such as particularly bad news from the upcoming AQRs, could tank cyclicals pretty easily.
Consensus growth expectations
“Consensus growth expectations look optimistic for Consumer Discretionary, IT and Financials; low for Utilities and Materials,” writes Secker. Utilities, materials, energy, and telecoms have the lowest margins versus history, while margins are high in the software, media, retail, staples, and auto sectors.
Morgan Stanley (NYSE:MS) has downgraded European consumer discretionary to Underweight because EPS, margins, and relative valuations are at record highs, and upgraded the European software sector to overweight because of upward earnings revisions a low sector valuations relative to history, roughly in line with consensus expectations.