European Stocks Starting to Look Attractive to Some
Several U.S. fund managers are starting to eye European stocks in spite of how poorly this region has performed for a long time. Is it time for us to start considering them as well?
Many people may be familiar with the concept of opportunity cost in economics, perhaps remembering it from a course they may have taken in basic economics in the past. Opportunity cost is a lot bigger deal than we think, with both finances and in life.
It is said that the essence of economics is to ultimately seek to measure opportunity cost so that we may be directed toward pursuing value more faithfully. This value often is financial value but opportunity cost extends well beyond that into the realm called utility.
Utility is another term for value, and value is a very broad standard that boils down to matching our actions with our preferences. This ultimately means happiness. We generally assume people want to be happy and we will make such assumptions as people want to maximize their risk/return ratio on investments because they will be happier with more money over less.
Economists are famous for assuming that people will act rationally, even though we often do not act this way and often we will not even come close to this. When it comes to investments, we may hold beliefs that are contrary to our overall interests and especially not consider opportunity cost enough or even at all in a lot of cases.
When we are in certain investments, like a basket of stocks for instance, we need to both ask ourselves whether the expected return on these investments is acceptable initially, whether it remains acceptable as the expectation changes over time, as well as the opportunity cost of these investments along the way.
Opportunity cost basically compares value between opportunities, and with stocks, this means the opportunity of a stock that you are holding versus something else that you could be holding instead.
There are two things that we see a lot with investors, which are their hanging on to positions well past the point where the opportunity cost should be directing them to other investments that are superior, and also having them spread their opportunities too thin in a quest for more diversification, even though the opportunity cost may well exceed any diversification benefits.
We are told that diversification is a good thing and as long as we don’t consider the opportunity costs of it, we may become fooled into thinking that this is beneficial in itself. There are some situations where you do want to use diversification, but only when it actually makes sense to, although in the majority of cases it does not but we do it anyway.
One example of this quest to over-diversify is with our wanting to expose ourselves to stocks and bonds issued in other countries. This might have made at least a little sense in bygone days, very bygone ones, when economies weren’t so connected. Nowadays, they clearly are, and things spread around the world like the sun does as the world turns.
This is not to rule out this sort of diversification, but we need to carefully examine what benefits this might hold and not just jump in with no better idea than diversification is always preferable or even generally so. There may be some opportunities elsewhere that may be so tempting that we want to prefer them straight up, but without these greater opportunities, they don’t really have enough to offer, and especially if the quality of opportunities is significantly less.
European Stocks Offer Both Higher Risk and Lower Expected Returns Right Now
European stocks have underperformed U.S. ones for many years, by an average of 10% per year over the last decade. If you had money in these lesser-performing stocks over this time, earning far less returns was not a matter of bad luck, but bad decision making.
Still though, we want to look at every situation with a fresh perspective, and if some people are now touting European stocks, we need to assess this based upon the usual criteria, their potential for gain and their risk versus the opportunities in U.S. stocks, the opportunity cost in other words.
Most people are aware of the economic challenges that are going on over there these days. While many people fear an economic slowdown in the U.S., this has already come home to roost over in Europe and is predicted to get worse over the next few years at least.
While the Federal Reserve Bank of the United States, or the Fed, has started taking corrective action to address the slowdown in their economy by ending quantitative tightening and giving us a couple of interest rate cuts, the European Central Bank, or ECB, has marshalled their entire army and is now in desperation mode with their latest stimulus package.
This won’t do much more than slow down the decline, and although the projections we have won’t have things getting too out of hand in the near term, when you have the sort of downward momentum in economic growth that we are seeing in Europe these days, there is a real risk that the weight of the decline will further collapse unto itself as things get slower and slower and people act more and more cautiously.
The latest activity from the ECB has some people more excited at least, and some are pointing to Europe as a real opportunity for stocks. When we look at the numbers though, the sort of revival that they are predicting isn’t likely to happen, and if it were this easy, they wouldn’t have fallen behind this much and have required the all-hands on deck approach we’re seeing now.
Italy is already in recession, and Germany is believed to be on the brink, with several other Eurozone members marching toward this line more and more. It doesn’t really matter why very much, although we can point out to Europe’s much greater willingness to sacrifice the economy to combat climate change, and these things do come with a real price.
Any time we increase the price of things, this causes demand to decrease, and this isn’t something that just might happen, it is a mathematical certainty that this will slow down the economy. Some may think that the very high carbon taxes that they have in Europe will just affect consumption of fossil fuels, but this factors into the price of virtually everything and its total impact upon an economy can be very significant.
If we were in a boom phase, one that central banks would be very eager to slow down with monetary policy tightening, carbon taxes and other measures to raise prices to achieve emission reductions would at least be swimming with the tide and would provide a desirable slowing down of the economy.
Europe’s Economy is Beat Down and a Lot of it is On Purpose
When you’re in the opposite situation, like we are now, with economic slowing, slowing it further is not such a good idea at all. Perhaps people would still choose this path, being willing to make the sacrifice needed, but we at least need to know what exactly is being sacrificed before we can even make an informed decision. Closing your eyes and pressing harder on the accelerator isn’t an approach that leads to enlightenment.
What has happened to the German auto industry gives us a taste of how sensitive things are now, and the 40% shrinkage of their business is widely blamed on the stricter emissions regulations that they became subject to last year. People may still want to buy these cars as badly, but people have a limited amount of money to spend, and when the price goes up for things, they will spend less on either that or overall, as income hasn’t kept pace with prices.
Carbon taxes only work if they actually do depress the economy significantly. This reduces the carbon footprint as they call it, but it also reduces the economic footprint, and they necessarily go together. This is not to say that this is a bad idea overall, but we have to be aware of the economic cost of all this to even be in a position to render a judgement. Overestimating the risks and our impact with climate change and virtually ignoring the costs of our actions against it won’t ever get us there.
This is the environment that European companies and their stocks now find themselves in, and why we need to be even more careful about looking to diversify our portfolios with them. A few of the better-performing stocks have been thrown around by some fund managers, but given the greater systemic risk in Europe, that alone should put an end to this discussion.
Fund managers on the whole woefully ignore systemic risk, and actually spend most if not all of their time looking at the business of companies that issue stock, and hardly any on where the market itself may be headed. When the market is headed down, it will take even the very good stocks with them, with few exceptions. This exception rate is too low to even want to pretend that you could do a good job at stock selection over the next few years with these systemic challenges.
If we want to diversify, we need to do so with an advantage or not at all, just to stay on the right side of rationality. There are always two considerations with an investment, which are risk and return, and European stocks fail on both counts when we compare them to comparable American stocks.
This is not to say that if we are skilled in our stock selection, we can’t seek out a positive return over there anyway, but the question needs to be whether we can consistently beat the returns of other stocks and therefore not pay too much in opportunity costs.
We don’t approach U.S. stocks this way enough though, and people will stubbornly ignore opportunity costs even when their present opportunities are terrible and there are opportunities that are clearly much better. This happens a lot not only among individual stocks, but with stocks in general as well, when the opportunity cost of investing in another asset class makes this clearly preferable.
Europe, with all their present problems, should not be a market that we should even be thinking about investing in right now, with things as risky as they are. When things become too risky for U.S. stocks, we should get out, but we’ve already passed this stage in Europe.
There may be a place and a time where these stocks one day become a bargain, where their risk/reward ratio becomes preferable, but this day is not today and probably won’t be for quite some time. As long as they are happy enough to slow their economy and make their businesses less competitive, we need to ask whether or not they will ever get out of the doldrums.
There’s more going on than this, but if someone is already sick and you give them something to make them sicker, this is the worst time to do it, as they are more vulnerable and this can take them to a particularly unwell place.
Even the best stocks are subject to too much risk under these circumstances, so the wisest approach is to allow others to court the likely degree of regret that comes with choosing lesser value over greater, especially with value so hard to come by over there these days, reducing the odds of your getting lucky.
Stock investing does involve placing bets on them but this should not be approached like gambling, but rather be a product of informed and deliberate analysis. Investing in Europe doesn’t make the grade right now.
Editor, MarketReview.com
Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.
Contact Eric: eric@marketreview.com
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