What Will It Take For Europe To Outperform?

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What Will It Take For Europe To Outperform?

Going back to December of 1970 (the earliest for which I can find data), the Wilshire 5000 total return index has posted 10.65% annualized returns (through April of this year), versus 10.4% for the MSCI Europe total return index.  Given the fairly similar annual performances of the indices, one would be tempted to think that they have tracked relatively similar paths along the way to achieving those returns.

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However, a look at the relative rolling 10-year performances for the two indices reveals long cycles of fairly dramatic relative over- and underperformance, with the current period of European underperformance being the worst on record:

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With Europe looking relatively cheap compared to the U.S., its markets are attracting the attention of many asset allocators.  However, just because something is cheap is not necessarily a catalyst in itself for outperformance; it is simply a bet on mean-reversion.  That being said, what factors might it take for Europe’s next cycle of outperformance relative to the U.S.?

Perhaps the U.S. market, which is currently dominated by technology shares, might suffer as tech falls out favor, similar to what happened in the wake of the tech boom and bust in the late 1990s – early 2000s, which, coincidentally, was the beginning of Europe’s last cycle of outperformance relative to the U.S.

Another factor might be the return of health to Europe’s banking sector, which is the largest weighting in the MSCI Europe index.  Given the trouble in the banks of nations like Italy and, to a lesser extent, Germany, this seems unlikely.

The easiest case to make for Europe’s resurgence, in my opinion, is another weak-dollar cycle.  Tracking the relative performance of the two indices – this time using 3-year rolling averages – when plotted against 3-year changes in the U.S. dollar shows how important changes in the value of the dollar is to U.S. vs foreign equity performance:

Europe

As the chart shows, when the dollar is strong, U.S. equities tend to outperform, and when the dollar is weak, foreign equities (in this case, European equities), tend to do better.  In fact, the two series are 73% correlated over the period observed, so there’s a very good case to be made that when the dollar does turn for a period of weakness, European shares should do better, though that is obviously no guarantee that they will.

For further reading:

Investing in Europe:  Where’s the Return?  – Michael Batnick, CFA, via CFA Institute’s Enterprising Investor

Understanding the Impact of the Dollar on Foreign Equities – myself

This article first appeared on http://www.fortunefinancialadvisors.com

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1 COMMENT

  1. The graph shows that there’s a correlation between the USDX and US stocks outperforming. But there is no explaination of causation. Do US stocks outperform because the USD gets stronger, or does the USD get stronger because US stocks outperform? Without a reasoned discussion of this point, the conclusion in the last sentence is not justified.

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