Do Longer-Term Metrics Make European Stocks More Attractive?

August 30, 2012

Most investors are familiar with the PE ratio as a metric of valuation. This metric divides the current stock price by trailing twelve month earnings. In effect, it measures how much an investor pays compared to the amount of earnings a company or index provides. As a measure of valuation, PE can be heavily influenced by the cyclical nature of earnings. To smooth out fluctuations due to cyclicality, one approach, popularized by Robert Shiller, is to divide equity index prices by ten-year average earnings. The measure, known as the Cyclically Adjusted PE (CAPE), can provide an indication of when markets are exceptionally over or undervalued.

This week’s Chart of the Week shows CAPEs for market stock indices of 47 countries including the United States. The U.S. comes in at the middle of the pack, with a CAPE of 19.6. This is much higher than the trailing 12-month PE of 13-14, due to the large declines in earnings suffered over the last ten years. Perhaps unsurprisingly, the countries with the lowest CAPEs reside in peripheral Europe. Greece, with a CAPE of 3.0, looks extremely undervalued by this measure. Spain and Italy, which are both home to large multinational corporations, have CAPEs just below 10. The Netherlands, which is a net lender in the Eurozone, has a CAPE below 10.

Of course, while low valuations have tended to precede strong long-term performance, this is by no means guaranteed. Additionally, given the ongoing nature of the Eurozone crisis, short-term performance of European equity markets is likely to be choppy at best. The Athens Stock Index, for example, is down 49% over the last year alone. Still, on a relative valuation basis, European equity markets look attractive compared to other countries for long-term investors.