As Fears of Crisis Increase, European Equities Trade at Huge Discount

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The composite valuation indicator (CVI) is a measure that Morgan Stanley uses to measure the value of MSCI Europe equities relative to bonds and inflation. Morgan Stanley (NYSE:MS) analysts use a variety of weighted indices on real and nominal bond yields, dividend yields, and some equity valuation indicators like Price (P)/Earnings (E) and P/Book Value (BV) to construct the CVI. The model indicates buy and sell signals and are based on z-scores for these weighted factors. The buy and sell levels are -1 and +1 respectively. The way Morgan Stanley uses this model is that at zero equities are fairly valued, at +1 Morgan Stanley analysts will prefer to buy bonds/cash and at -1 Morgan Stanley (NYSE:MS) analysts are equity buyers. This week’s reading is at -1.1, which indicates a buy signal for European equities.

European Equities

The fundamentals, risk, and capitulation indicators are broadly similar to the CVI. Factors included in these indicators, however, are different from the ones included in the CVI. These indicators include business surveys, momentum indicators (as a proxy for market sentiment), return on equity, bond yields, credit spreads, fund flows, and money supply. As with CVI, the latest reading is expressed like a z-score once a month. This month, the fundamentals reading is +0.1 and the risk indicator is at +0.1. Both readings are close to neutral, and a buy signal for both indicators starts at -0.5, and a sell signal starts at +0.5. Finally, the combined market timing indicator is the average of the CVI, risk and fundamentals indicators. This indicator shows a buy signal when it is below -0.5 and a sell signal when it is above +0.5. June’s reading is -0.3.

Market timing indicators backtest

Morgan Stanley Analysis of European Equities

MSCI Europe’s trailing valuation measures such as Price/Cash earnings (CE), and Price/Earnings are close to 40 year averages. Dividend yields have declined and are slightly below 40 year averages at 3.7 percent. Forward valuations are also close to long term averages; however Price/Book Value for European equities of 1.58 is below the long term average of about 1.7.

MSCI UK seems to be undervalued on a P/E basis relative to MSCI Europe ex UK. The trailing P/E and P/CE for MSCI UK is 12.9 and 7.9, respectively. For MSCI Europe ex UK, the trailing P/E and P/CE is 15.7 and 7.7, respectively. The P/E and P/CE ratios for MSCI Europe ex UK have declined relative to May. Dividend yields are comparable in MSCI UK versus MSCI Europe ex UK, at 3.8 percent and 3.6 percent, respectively. Relative to U.S. equities, MSCI Europe excluding UK is more attractively valued on a P/E and P/CE basis; as the respective measures for U.S. stocks are 16.8 and 10.6. European equities are currently trading at about a 35 percent discount relative to U.S. stocks. Japanese equities are even more expensive, with P/E of 19.6 and P/CE of 7.9. Dividend yields for U.S. and Japanese equities are lower than comparable yields in European equities, coming at 2.1 percent for U.S. stocks and 2.0 percent for Japanese shares.

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European Equities That Have Upside Potential: Morgan Stanley

Countries that have more attractive valuations and upside potential, according to Morgan Stanley analysts, include the Nordic countries, Norway, Italy, and Austria. Market participants are underweighted relative to the MSCI Europe benchmark in these countries. Germany, France, Portugal and Greece are also cheaply valued but market participants are either neutral or overweight in these countries versus the benchmark. If investors are looking for income within European equities, Belgium, Italy, Portugal, UK, and Spain offer dividend yields above the average of 3.7 percent for 2013.

Regarding growth in European equity sectors, Morgan Stanley (NYSE:MS) analysts believe that materials, healthcare, financials, utilities, energy, and telecommunication stocks are undervalued and under owned (investment managers are underweight these sectors relative to the MSCI Europe). Sectors that present earnings growth for the next 10 years and are both under owned and cheap include materials, financials, utilities, and healthcare. Such sectors could present profitable investments within the European equity universe.

market implied next 10Y eps growth

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